It's no secret that Warren Buffett likes financial sector stocks, as you'll find several major banks among Berkshire Hathaway's massive stock portfolio. And in 2022, a new bank stock has been added to the portfolio: Ally Financial (ALLY -0.83%).
Berkshire bought about 3% of Ally's outstanding shares in the first quarter, but more than tripled its position in the second. The conglomerate now owns about 9.3% of Ally, a stake worth just over $1 billion. And after some digging, Ally has jumped to the top of my own watch list. Here's why.
Ally Financial's business -- the short version
Ally Financial has been around for a long time, but prior to the financial crisis was a subsidiary of General Motors known as GMAC Financial.
With this in mind, you might guess that a major focus of Ally is auto lending, and you'd be right. But in recent years, the company has evolved into so much more. It has a large insurance brokerage that has a natural source of customers through its auto loan platform. And Ally also operates a successful online bank that offers high-yield deposit accounts, mortgages, personal loans, credit cards, and an investment platform. In all, Ally Bank has about 2.5 million retail customers, which has more than doubled over the past five years. Ally is the largest all-digital direct U.S. bank and has grown its customer base for 53 quarters in a row.
Why is Ally such an interesting investment?
For one thing, Ally is an extremely profitable business. Consider its auto lending operation. In the second quarter of 2022, Ally originated $13.3 billion in auto loans at an average yield of 7.8%. Meanwhile, Ally Bank has about $140 billion in deposits (which it uses to fund its lending operations) that pay an average interest rate of just 0.76%. Its annual net charge-off (NCO) rate is less than 0.5%. It doesn't take heavy mathematics to see why this can be a lucrative business.
Ally generated an average 16.9% return on equity over the past four quarters, far greater than the typical bank, fueled by both the high-yield nature of its lending products and the cost advantages that come from being an online bank.
Not only is Ally profitable but its stock is cheap. It trades for less than 0.95 times book value and just over five times earnings. For context, mega-bank JPMorgan Chase trades for 1.41 times book and about 10 times earnings, despite having significantly lower ROE and interest margins. Even Bank of America, which is Berkshire's largest bank stock investment and is often regarded as a "cheap" bank stock, trades for 1.2 times book.
Last but certainly not least, Ally is doing a great job of returning capital to shareholders, which likely has a lot to do with Buffett's investment thesis. It has a 3.3% dividend yield, but the main focus of the company's capital return is buybacks -- not a surprise considering it is literally trading for less than the value of its assets. In the first half of 2022 alone, Ally spent $1.2 billion on share repurchases, an extremely aggressive rate for a company whose market cap is about $11 billion. Since 2016, Ally's outstanding share count has fallen by more than 36%, and buybacks like this can become a major driver of shareholder returns over time.
Is Ally Financial a buy right now?
To be perfectly clear, it's not a good idea to jump into any investment simply because a billionaire investor does, even if that billionaire investor is named Warren Buffett. Having said that, it's not difficult to see why Buffett (or someone on Berkshire's investment team) might be a big fan of the bank.
There are some risk factors to be aware of. For one thing, the auto industry is certainly facing some short-term headwinds, such as supply chain disruptions. And if the economy falls into a recession, we could see higher defaults and lower demand for new loans. However, given the bank's success and profitability, the risk-reward profile of the stock seems very favorable for patient long-term investors.