Legendary stock market investor Warren Buffett is more widely known for the stocks he buys that go up, but they can't all be zingers. Shares of consumer-focused bank Ally Financial (ALLY 0.41%) have fallen since Buffett added the stock to Berkshire Hathaway's equity portfolio in early 2022, and it's down about 42% from the peak it reached in 2021.
Berkshire Hathaway sold 14 stocks during the third quarter of 2023, seven of which were closed out completely. One that didn't land on the chopping block, though, was Ally Financial.
Last year was a banger for the overall stock market, and Ally Financial rose 43% in 2023, but it still looks like a bargain. Here's why investors seeking dividend income might want to buy it now and hold for the long run.
Old not stodgy
Ally Financial began over a century ago as the financial arm of General Motors, but spun off and rebranded itself as Ally Financial in 2010.
Ally may be one of America's oldest banks, but it isn't behind the times when it comes to online banking. Its services are 100% digital; it doesn't have any physical branches. This is a big advantage because it doesn't have the staffing and real-estate-related expenses that come with traditional bank operations.
As you can imagine, Ally originates a lot of auto loans, and not just to GM dealerships. The company processed 3.7 million consumer auto applications in the third quarter, which was a new company record. The gap between interest paid to depositors and interest earned from outstanding loans contracted in the third quarter, but at 3.26%, Ally's net interest margin is still strong enough to generate a healthy profit.
Ally has an above-average dividend that could rocket higher
At recent prices, Ally Financial stock offers a healthy 3.6% dividend yield that could grow by leaps and bounds over the years ahead. Over the past five years, the company has increased its dividend payout by 76.5% and we could see similar increases in the years ahead.
Despite a net interest margin that narrowed recently, Ally Financial's consumer banking operation generated $3 billion of free cash flow during the 12 months that ended last September. That was nearly eight times more than it needed to meet its dividend commitment over the same time frame.
The average interest rate on new auto loans jumped to an estimated 10.7% in 2023 compared to just 7.1% in 2021. As its balance sheet turns over, recently originated loans at a higher interest rate could drive Ally's net interest margin to new heights.
The yield that Ally is paying on deposits is around 4% right now. With the Federal Reserve expected to cut rates in 2024, Ally's interest expenses are likely to improve or at least stabilize.
Stabilizing interest rates, plus heaps of higher-interest auto loans entering its books have Ally confident that its net interest margin will pop back above 4% in this year or next.
What to watch for
The end of pandemic-related stimulus combined with soaring inflation hasn't been the disaster that many investors feared it would be. Ally's auto-loan charge-off rate reached 1.85% in the third quarter. This is relatively high, but it's still a long way from unmanageable.
Ally has prepared for a much higher charge-off rate by holding its dividend payment steady since early 2022. If we see signs that the recession Ally is preparing for isn't going to happen, such as improved charge-off rates, the bank could announce a big dividend raise before the end of 2024.
A bargain now
Shares of Ally have been trading for roughly 1 times the bank's tangible book value and 9 times trailing-12-month earnings. At this low valuation, investors can come out way ahead over the long run even if Ally's business never grows.
Ally's recent performance and a resilient U.S. economy make significant growth in the years ahead seem a lot more likely than stagnation. Put it together and this bank looks like it would make a great addition to just about any income investor's portfolio.
