In case you haven't heard, Warren Buffett, the chairman and CEO of Berkshire Hathaway (BRK.A -0.87%) (BRK.B -0.86%), recently bought some stocks for his holding company. Two of the new buys were from his favorite industry, banking: Ally Financial (ALLY -0.70%) and Citigroup (C -1.89%).
If the Oracle of Omaha is adding these companies to his conglomerate's portfolio, they must have something going for them. Let's take a look at both and see what makes them so appealing. And because we might need to be selective about which stock we buy because of limited available funds, let's try to determine which of the two is the better buy.
In the first quarter, Buffett and Berkshire Hathaway opened a small position in Ally Financial, an online bank that was originally the auto financing arm of General Motors before it spun off in 2010. Berkshire bought about 9 million shares valued at roughly $390 million.
Ally is a full-service bank with $184 billion in assets, making it the 22nd largest in the U.S. It is also the largest fully online bank and the largest auto lender in the country. Its auto lending business has driven its revenue over the years.
In the first quarter, nearly three-quarters of its $1.7 billion in net financing revenue came from auto loans. And while auto sales were softer than expected in the first quarter, Ally had its best first quarter in 11 years with loan originations up 14% year over year to $11.6 billion with yields over 7%.
The latest report from Cox Automotive shows that auto sales in 2022 are expected to be 20% lower than in 2021. That estimate is down from earlier projections due to slower expected economic growth. Ally outperformed in Q1 and its solid financials suggest that it is in good shape to weather a potential downturn.
For starters, its delinquencies remain lower than normal at just 0.6% of its loan book. Also, its efficiency ratio is just 45.6% -- which means that for every dollar of revenue, it deploys 45.6% to cover expenses. It also has a high operating margin of 44%, and these numbers reflect the fact that Ally has less overhead than its peers because it doesn't have the physical branches.
The other attractive quality for Ally is its valuation, which is extremely low. It is trading below book value with a price-to-book ratio of 0.95 and a high return of tangible common equity (ROTCE) of around 24% -- two indications of an undervalued stock.
Citigroup is the third-largest bank in the country with $2.3 trillion in assets, but it is the only megabank that Buffett and Berkshire have not owned in recent years -- until now. That's because Citigroup has lagged its peers, for the most part, and had some high-profile internal controls issues that led to federal fines. But the bank is in process of righting the ship, investing more than $1 billion to address its risk-management issues and streamlining its strategy under new CEO Jane Fraser.
The last year or so has been a transition period for Fraser and Citigroup, grappling with higher expenses as it resets its strategy. Fraser's plan is to sell off its underperforming banking businesses in some international markets and reinvest in others while focusing on bolstering two growth areas -- banking and wealth management. Citigroup also had greater exposure in Russia than other banks, so it was hit with losses there, too.
So far this year, the stock price is down about 12.8% year to date, which is better than the two larger banks, JPMorgan Chase (down 20.3%) and Bank of America (down 19.5%), the latter of which Berkshire also holds. The planned changes at Citigroup have apparently been enough to make Berkshire buy some 55 million shares at a value of about $3 billion.
Most certainly, Buffett also likes its valuation, which is extremely low. It has a low price-to-book value of just 0.54, although its ROTCE is also low at 10.5% and is projected to be in the 11% to 12% range over the next couple of years, Fraser said at the recent Investor Day. Also, it has a forward price-to-earnings (P/E) ratio of just 7.
Which is the better buy?
It's clear to see why Buffett favors these stocks -- they are both banks, and he loves bank stocks. Also, they are both undervalued, and he likes value stocks. In addition, the purchases come at a time of rising interest rates, which Fraser expects to rise another 200 basis points this year over its current levels. This should help banks in general, although much depends on whether or not inflation gets under control and the U.S. avoids a recession.
At this point, there's too much uncertainty with Citigroup as its turnaround will take time, with a lot of moving parts -- and it comes at a volatile and uncertain time in the markets and the economy. That said, I like its long-term prospects, but if I was going to buy one of these stocks right now, it would be Ally.
Ally stock is dirt cheap, with solid financials and low overhead, and it has carved out a great niche in the auto lending business. And lots of pent-up demand in that space, along with higher interest rates, should drive revenue over the next couple of years, depending on, of course, how the economy trends. Ally also has a good dividend with a 3.1% yield and a minuscule 11% payout ratio, one that is easily sustainable and points to the potential for increased dividends in the future.