Warren Buffett attracts a lot of attention. As the world's third-richest person and most celebrated investor, thousands try to glean what they can from his thinking processes and track his investments.
While we can't know for sure whether Buffett is about to buy Bank of America
In his most recent 10-K, Buffett lays out the qualities he looks for in an investment. In addition to adequate size, proven management, and a reasonable valuation, he demands:
- Consistent earnings power.
- Good returns on equity with limited or no debt.
- Management in place.
- Simple, non-techno-mumbo-jumbo businesses.
Now, Buffett’s company briefly owned a small position in Bank of America that it sold in late 2010. But does Bank of America meet Buffett's standards?
1. Earnings power
Buffett is famous for betting on a sure thing. For that reason, he likes to see companies with demonstrated earnings stability.
Let's examine Bank of America’s earnings history:
Source: Capital IQ, a division of Standard & Poor's. Free cash flow is adjusted based on author’s calculations.
Over the past five years, Bank of America’s earnings have shrunk considerably, largely due to the financial crisis, stalling loan growth, regulatory restrictions on fees, and potentially vast legal liabilities, many of which it inherited from the disastrous Countrywide purchase.
2. Return on equity and debt
Return on equity is a great metric for measuring both management's effectiveness and the strength of a company's competitive advantage or disadvantage -- a classic Buffett consideration. When considering return on equity, it's important to make sure a company doesn't have an enormous debt burden, because that will skew your calculations and make the company look much more efficient than it actually is.
Since competitive strength is a comparison between peers, and various industries have different levels of profitability and require different levels of debt, it helps to use an industry context. I’ll be using a leverage ratio defined as assets divided by equity, which is more appropriate for banks. In the United States, about 10 to 12 times is considered normal.
|
Company |
Leverage Ratio |
Return on Equity (LTM) |
Return on Equity (5-year average) |
|---|---|---|---|
|
Bank of America |
10.2 times |
(7%) |
7% |
|
Citigroup |
11.0 times |
6% |
0% |
|
JPMorgan Chase |
12.3 times |
11% |
9% |
|
Wells Fargo |
9.1 times |
11% |
13% |
Source: Capital IQ, a division of Standard & Poor's.
Bank of America generated a moderately low return on equity over the past five years and a negative one over the past twelve months. It employs a moderate amount of leverage.
3. Management
CEO Brian T. Moynihan has been at the job since 2010. Prior to that, he’d been president of various Bank of America divisions and General Counsel for several years after working at FleetBoston Financial, which Bank of America acquired in 2004.
4. Business
The banking industry may not be especially susceptible to technological disruption, but particularly at the megabank level it is susceptible to the risk that goes along with mind-blowing complexity and opacity. One of Buffett’s largest investments is Bank of America peer Wells Fargo, though it is reputed to dabble less in the most esoteric areas of too-big-to-fail banking.
The Foolish conclusion
Whether or not Buffett would buy shares of Bank of America, we’ve learned that, while it operates in an industry with which Buffett tends to feel comfortable, it doesn’t exhibit some of the other quintessential characteristics of a Buffett investment: consistent earnings and high returns on equity with limited debt.
If you’d like to stay up-to-speed on the top news and analysis on Bank of America or any other stock, simply click here to add it to your stock watchlist. If you don't have one yet, you can create a watchlist of your favorite stocks by clicking here.
