It's been a couple months since my Special Situations portfolio acquired more warrants in Bank of America (BAC -0.21%) (BAC-WTA), and now I'm back to buy more. The warrants offer a supercharged way to invest in the bank, and I think they could easily see 20% annualized returns from here until they expire in January 2019. You can read the original buy recommendation here.
All the ongoing legal issues – including massive settlement payments – are obscuring the real value at B of A. And they are significant, but not crippling, and they steal the headlines from the solid underlying performance at the bank. For example, in the four quarters ended March 31, B of A put up its strongest pre-tax earnings performance since 2007, notching over $23 billion in pre-tax income. Then nearly $10 billion in legal settlements dented that.
But the fundamental business still looks solid. And so we need to look beyond all the negativity in the headlines. That creates a huge stigma and blinds many investors to the opportunity here. Indeed, it creates an excellent opportunity for me and others – including Warren Buffett -- to buy a solid bank at a very good price.
The benefit of the warrants is that they leverage the stock's performance and offer even more gain. And the fact that they're so long term is a huge bonus. The market is tremendously inefficient at pricing long-term options, and so that offers another nice opportunity.
As I noted in my original write-up: "The warrants have another interesting feature, a so-called anti-dilution provision that, among other things, protects warrant holders if B of A pays dividends greater than $0.01 per quarter. In effect, warrant holders get to collect that dividend via a provision that lowers the effective strike price of the warrants." So warrants get to collect on that dividend via a lower strike price.
Foolish bottom line
What I wrote in my original recommendation still holds today: "I expect lollapalooza effects from this investment over time. Bank of America will continue increasing its profitability substantially over the next five years, allowing the stock to trade at a higher multiple. Then I'm layering warrants onto the investment case for even more leveraged upside, and dividends and buybacks help, too. So, that's why my Special Situations portfolio is adding $500 in January 2019 warrants." I'll continue looking to add to that on any significant dip. Interested in Bank of America, or have another stock to share? Check out my discussion board or follow me on Twitter, @TMFRoyal.
