As stocks were getting creamed in the first three months of the year, legendary investor Warren Buffett and Berkshire Hathaway (BRK.A -0.62%) (BRK.B -0.46%) went on a shopping spree -- particularly in the financials sector.
In Berkshire Hathaway's Form 13F regulatory filing, which shows what stocks the conglomerate bought and sold in the first quarter, the company revealed that it had bought a stake in embattled megabank Citigroup (C 0.60%). Berkshire purchased 55.2 million shares, or roughly 2.8% of Citigroup's outstanding shares, for a total value of roughly $2.95 billion. Berkshire's average cost per share was about $53.40.
Citigroup stock was down about 21% this year at Monday's close, nearing levels not seen since the brunt of the pandemic in 2020. Is this a good time for Berkshire -- or anyone else -- to own it?
A deep value play
Buffett has long been known as a value investor -- he tries to find stocks trading below their intrinsic value that he thinks should be valued higher. Right now, there is no better value play in the banking sector than Citigroup. It currently trades at less than 60% of its tangible book value, which is essentially a bank's net worth.
As you can see above, Citigroup trades at a significant discount to its peer group. There is good reason for this, of course. For years, the bank has generated lower returns than its peers and failed to clean up its act from a regulatory perspective.
In 2020, federal regulators hit Citigroup with a $400 million fine. At the same time, the U.S. Office of the Comptroller of the Currency (OCC), which regulates national banks, issued a cease-and-desist order to Citigroup for failing to improve internal controls related to compliance, data, and risk management.
These regulatory issues resulted in Citigroup significantly increasing expenses in 2021, with expenses also expected to be high this year as well. Citigroup had more disappointing news at its investor day earlier this year, when it announced it was only targeting an 11% to 12% return on tangible common equity in the medium term, well below other major bank return targets.
That said, Citigroup's former CEO, Michael Corbat, stepped down right around the time the regulatory order was issued, and the bank elevated Jane Fraser to replace him. Fraser wasted little time, announcing a strategy refresh. The bank announced plans to sell many of its international consumer banking divisions, including its very profitable operations in Mexico. Citigroup also plans to double down in areas where it's already strong, including investment banking and wealth management.
Paid to wait
Citigroup's transformation plan is likely to take several years. But in the meantime, Buffett and Berkshire will be well compensated, which I suspect is one of the reasons Buffett likes Citigroup. At Monday's share price of $47.46, Citigroup had an annual dividend yield of 4.3%. Furthermore, that represents a modest dividend payout ratio of 28%. Banks, in general, usually have payout ratios in the 30% to 40% range, so there is room to grow this dividend in the future.
However, Citigroup will likely use any excess capital to repurchase its own stock, which it did last year and in the first quarter of 2022. For banks, buying back stock below tangible book value is extremely beneficial, because repurchases grow tangible book value. Banks trade relative to this key metric, so a growing tangible book value tends to benefit the stock in the long term.
Citigroup may be limited in its repurchase ability for the remainder of the year, due to regulatory capital constraints, but management has made it clear that it will conduct modest buybacks this year when it can. Additionally, as the bank completes the sales of its international consumer banking divisions, that will free up capital the bank may be able to use to repurchase shares.
This could be a great play for Buffett -- how about you?
Citigroup's road is not easy. There will also be tremendous skepticism from the market after years of broken promises. Buffett knows this, and with Berkshire's stake at less than $3 billion, Citigroup makes up less than 1% of its $340 billion equities portfolio.
But with a fairly new management team in place, a clear transformation plan, and such a discount in its stock price, I think Citigroup could be a great long-term investment right now. After all, if Citigroup could trade at just tangible book value -- which would still put it at a steep discount to its peers -- it would trade at $79 per share, which implies more than 60% upside. And while you wait for the transformation to happen, you will make good money on Citigroup from the dividend and any near-term share repurchases.