What will Berkshire Hathaway (BRK.A -0.10%) (BRK.B -0.36%) do with the Bank of America (BAC -0.10%) warrants it owns when they expire in 2021? Warren Buffett answered this question at the annual meeting last weekend, suggesting that if the warrants were to expire today, he'd definitely want to keep the stock.
Almost immediately, members of the media read through the lines to suggest that Buffett is bullish on Bank of America, but that's not quite true. His supposed bullishness comes with a very big caveat.
Mind the taxman
Nothing Buffett says or does should be taken at face value, as there's always some nuance at play. For Buffett and Berkshire, the issue isn't whether Bank of America is a good deal at a recent closing price of about $24 per share. The issue is whether Bank of America is a good deal relative to the opportunity cost of paying taxes on the gain and investing in something else.
Buffett is notorious for legally avoiding Uncle Sam's tax collectors, preferring a deferred gain to a realized gain. Exercising a warrant and taking ownership of common stock isn't a taxable event. Thus, he can defer taxes on the tremendous gains earned on Bank of America warrants by turning those warrants into B of A shares.
Buffett ultimately has to decide which of these two scenarios is better:
- Holding Bank of America shares that are valued by the market at roughly $24 each; or
- Exercising the warrant, selling the stock, and having the equivalent of $18.07 in after-tax cash per Bank of America share (roughly 25% less value).
To put it in simpler terms, I'll ask this question: Would you rather have $100 worth of Bank of America shares or $75.40 to invest in any other stock? This is essentially the same question that Buffett has to ponder, but at a much larger, multibillion-dollar scale.
Any other investment worth about $75 would have to be markedly better than the bank to beat the returns generated by $100 of Bank of America stock. In effect, the B of A stock has a 33% head start.
Why you shouldn't blindly follow Buffett
This is just one of the many reasons why I think investors have to be very careful when they try to follow Warren Buffett's stock picks and commentary. Earlier this year, Charlie Munger explained that Buffett is investing very differently than he used to, telling an audience of Daily Journal shareholders that Berkshire bought ExxonMobil in 2013 as a cash substitute, believing that the oil giant's shares were better than a microscopic return on cash.
With more than $90 billion of cash, it's not remotely surprising that Buffett sees roughly $16.8 billion of Bank of America stock being better than having $12.7 billion in after-tax cash. It's even less surprising that Buffett would choose not to talk down a stock four years before he gets the chance to sell it.
The correct read is that Buffett implied he is bullish on Bank of America if the bank has a 33% head start on any other stock. That's not exactly a glowing endorsement, but it is an accurate report of the underlying question he answered last weekend.