Bank of America (BAC 1.53%) must be feeling pretty good right about now. It has long since turned the corner on the financial crisis, its share price doubled in the past year, and now the icing on the cake: Warren Buffett called out the North Carolina-based bank in his latest letter to the shareholders of Berkshire Hathaway (BRK.A 0.64%) (BRK.B 0.54%).
Buffett's investment in B of A
In 2011, Berkshire Hathaway became one of Bank of America's biggest investors. The Buffett-led conglomerate purchased $5 billion worth of preferred stock at the time, which came with warrants to purchase 700 million shares of common stock for $7.14 a share at any time before the middle of 2021.
Warren Buffett, chairman and CEO of Berkshire Hathaway. Image source: The Motley Fool.
The preferred stock in and of itself was a good deal, yielding 6%, or $300 million a year in annual dividend payments. But it's the warrants to purchase Bank of America common stock that have turned out to be extraordinarily lucrative.
At today's share price, Berkshire's warrants are worth $12.2 billion. If you add that to the $5 billion in preferred stock plus the dividends that have been paid on that stake, that means Berkshire's investment in Bank of America has nearly quadrupled in less than six years.
One of the questions the situation raises is this: When will Buffett exercise Berkshire's warrants, and how will he do so? Will he just sell the warrants or will he convert them into shares of common stock?
Buffett weighs in
In Buffett's annual letter, released on Saturday, he provided some insight. He first noted that Berkshire Hathaway could use its preferred stock to satisfy the $5 billion cost of exercising the warrants -- 700 million shares times $7.14 a share equals just under $5 billion.
He then went on to note, however, that whether Berkshire exchanges its preferred stock will depend on Bank of America's dividend at that time:
If the dividend rate on Bank of America common stock -- now 30 cents annually -- should rise above 44 cents before 2021, we would anticipate making a cashless exchange of our preferred into common. If the common dividend remains below 44 cents, it is highly probable that we will exercise the warrant immediately before it expires.
This makes sense because an annual dividend of $0.44 a share, on a basis of $7.14 a share, equates to a 6.1% yield, which is slightly higher than the yield Berkshire earns from its stake in Bank of America's preferred stock.
Beyond that, Buffett went on to seemingly prod Bank of America to continue buying back stock:
Many of our investees, including Bank of America, have been repurchasing shares, some quite aggressively. We very much like this behavior because we believe the repurchased shares have in most cases been underpriced. (Undervaluation, after all, is why we own these positions.) When a company grows and outstanding shares shrink, good things happen for shareholders.
From this, it's clear that Buffett is focused not only on Bank of America's underlying operations but also on the way it allocates capital. This happens to be Buffett's strongest skill set, and it also happens to be the force behind some of the best corporate returns over the past half-century, as William Thorndike lays out in The Outsiders.
For investors today, it's tempting to blindly follow Buffett's lead into companies like Bank of America. But keep in mind that he purchased the stake at the nadir of the bank's post-financial crisis problems, and that its shares have since roughly quadrupled in price. That isn't to say Bank of America's isn't a good buy at today's price, but it's nowhere near as cheap as it was when Buffett piled into the stock nearly six years ago.
