In the wake of Bank of America's (BAC 1.53%) $17 billion settlement with the U.S. government, my Special Situations portfolio is buying more warrants on this megabank. The warrants offer huge leveraged upside on the return of a normal economic environment, and with the bank already undervalued, they should easily return 20% annually until expiring in 2019.
I last purchased Bank of America warrants in early August, and today with the $17 billion settlement in the rearview mirror, there's even more reason to like the company. The year ahead looks great. Analysts project $17 billion in earnings, putting the stock at just 10 times next year's earnings. That prices in almost no growth. Then we're stacking the leverage power of warrants onto the trade for an extra boost.
And the bank has a huge vote of confidence from one of the world's top investors. Warren Buffett owns his own special class of warrants (with a strike price of $7.14) to buy 700 million shares of the company. If the warrants were exercised, Buffett's company would become the largest shareholder of Bank of America.
The bank just initiated a quarterly dividend of $0.05 per share. The warrants allow holders to capture this dividend in the form of a lower strike price. For dividends in excess of $0.01 per quarter, the surplus reduces the strike price by an equivalent amount. The starting strike price for the warrants is $13.30, so for now each quarterly dividend should lop off $0.04 from that strike.
In future years, I expect increased dividends to bring down that strike price even more. Further dividend increases in later years could really juice the return here. For more on the warrants, follow me on Twitter: @TMFRoyal. And check out my dedicated discussion board.
Foolish takeaway
My Special Situations portfolio is buying more Bank of America warrants, adding another $500 to my position. I think 20%+ annual returns are a real possibility here.
