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Fairholme Funds --> Case Study: Bank of America


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It looks more like an ad for Bank of America than an analysis.

for instance, what is the potentiel cost of litigations In a worst case scenario? How could it impact dilution?

 

I suspect the slide showing $30-50B in operating cash flows, $200B in equity, and $50B in reserves is Berkowitz's way of saying, that dilution due to litigation should not be a big enough issue to discount market value at less than a third of equity and half of tangible equity.  Sometimes the obvious answer is obscured by the details.  The markets are presently dissecting the details, and ignoring what is staring them in the face.  Cheers!

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I don't think 200b$ shareholders equity is relevant: There are 85B$ goodwill and intangibles and 18B$ preferred stock . Common tangible is more 125B$  To write 200 B$ In a presentation is misleading, from a common stock poit of view.

From a preferred perspective, There is a margin of safety: 125B$+50b$ reserves=175b$ seems enough to cover litigations and credit losses in a worst case scenario.

From a common perspective, i don't think it to be obvious except maybe if you have insight about the maximum losses on litigations or at least some reasonning about them. I don't see any In this presentation.

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Overall, our analysis agrees with Berkowitz's conclusion that Bank of America is undervalued.  However, some of the information in his presentation is a bit sloppy.

 

On slide 8 ("when others are greedy"), he shows how Fairholme raised cash when the S&P was riding high at the end of Q1.  The chart shows that the S&P had barely changed by June 30, yet Fairholme had already deployed most of its available cash.  This does not exactly prove the point the slide is trying to make.

 

On slide 11, the math is too simplistic.  The last step, i.e., getting from 10% to 20% is wrong because the variable that matters most in that context is time.  If it takes 20 years for the discount to close, the return will stay pretty close to 10%.  If it takes only one year, the return will be above 100%.  So, to say that the implied annual return is 20% is fairly meaningless.

 

Slide 15 is not exactly helpful to Fairholme's case, because whenever you have the kind of aggressive asset growth in boom times, the assets could be less than of the highest quality.

 

Again, these details don't mean BofA is not a good investment, but we wish Berkowitz would have made a stronger case.

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On slide 8 ("when others are greedy"), he shows how Fairholme raised cash when the S&P was riding high at the end of Q1.  The chart shows that the S&P had barely changed by June 30, yet Fairholme had already deployed most of its available cash.  This does not exactly prove the point the slide is trying to make.

 

 

 

I think that is due more to redemptions than great market values.

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Has litigation ever killed a financial institution of BAC's strength ("strength" from a tangible assets point of view)?

 

How does BAC's likely earnings (assuming no growth) over the next 5 years compare to the likely liabilities?

 

It seems like the bears feel that BAC is the next AIG. Perhaps it is but I just don't see it...

 

Nor do I.  Strikes me the overhang is more from possible EU exposures now, rather than mortgage liability.  All banks are trading down on perception, rather than reality. 

 

Litigation can be spread over years if one chooses to fight it, rather than settle. 

 

They have converted a couple of billion of tier 2 to teir one common this past week in private deals with Institutions.  They have sold most of CCB for cash which removes most direct China property exposure.  Not a fan of headcount reductions having been victim to them but that has been ongoing and will reduce non-interest expense.  The recent spate of equity and bond issuances should bode well for ML - social media ipos come to mind.

 

Must say I like investing alongside BB rather than with him.  He bought at double my average prices.

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The last step, i.e., getting from 10% to 20% is wrong because the variable that matters most in that context is time.  If it takes 20 years for the discount to close, the return will stay pretty close to 10%.

 

It's just the expected earnings yield relative to the price paid for the stock -- that's all he is saying the 20% is from.  He is not saying it's the expected shareholder returns

 

The shareholder returns would be slightly under 14% if it takes 20 years for the gap to close to a 10% earnings yield.

 

Anyhow, the 20% number in his example has nothing to do with BAC.  He just threw it out there.

 

He could have used these numbers instead of using 20%:

51% earnings yield if you assume $3 earnings power

35% earnings yield if you assume $2 earnings power

25% earnings yield if you assume $1.45 earnings power

 

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Has litigation ever killed a financial institution of BAC's strength ("strength" from a tangible assets point of view)?

 

How does BAC's likely earnings (assuming no growth) over the next 5 years compare to the likely liabilities?

 

It seems like the bears feel that BAC is the next AIG. Perhaps it is but I just don't see it...

 

Nor do I.  Strikes me the overhang is more from possible EU exposures now, rather than mortgage liability.  All banks are trading down on perception, rather than reality. 

 

Litigation can be spread over years if one chooses to fight it, rather than settle. 

 

They have converted a couple of billion of tier 2 to teir one common this past week in private deals with Institutions.  They have sold most of CCB for cash which removes most direct China property exposure.  Not a fan of headcount reductions having been victim to them but that has been ongoing and will reduce non-interest expense.  The recent spate of equity and bond issuances should bode well for ML - social media ipos come to mind.

 

Must say I like investing alongside BB rather than with him.  He bought at double my average prices.

 

My ONLY problem with Berky is his timing which has been awful for about six quarters now.

 

WHAT he buys I have no problem with whatsoever.

 

I bet anyone who jumps into his positions NOW (SHLD, JOE, BAC, C, AIG, AIA) and went to sleep for 5 years would wake up VERY happy! 8)

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Some observations:

 

BoA grew assets by 3x (2250/750) over a 6 year period during the credit crunch. Created a hell of a BS strain; but as a good portion of that growth probably has an implied fed guarantee - the risk is not solvency, it is dilution.

 

The global credit mess is likely going to require all banks to hold more capital. That capital can only come from calling in loans, reserve releases from improving loan quality, asset sales, reduced exposure to the higher risk business lines, &/or dilution. Fewer assets, generating less margin, & dilution risk largely dependent on uncontrollable macro factors. Going forward, a lower earnings stream that could well end up spread over more shareholders.

 

It is implied that BoA remains as one entity over the ‘work-out’ period. That may not be reasonable, as most would expect regulatory & business incentives to develop - that spin the businesses into separate recapitalized ‘banking’ pillars. Going forward, multiple (& initially lower) earnings streams, virtually assured dilution, but capital in place to grow what are now healthy Balance Sheets.

 

At 35% dilution (guess), consolidated income needs to increase by 35% over ‘X’ years – just to maintain the current EPS. To make money during the period - either the P/E ratio must increase, or earnings must grow faster than dilution - & all with a high probability of it actually occurring. The longer ‘X’ is, &/or the lower the probability of it actually occurring, the lower the expected compound return will be. To offset the risk you need a very low cost base, but post ‘X’ this is a growth stock with the commensurate return.

 

There is a need to recognize the reliance on ergodicity (the longer the event path the more the eventual possible outcomes resemble each other). Just as a bad trade will catch up with you the longer you play, the same applies to the good trade. As long as BoA does not bankrupt - the longer the ‘X’ year period is, the greater the certainty in a return to ‘normal’.

 

Punch-card bet, but you have to be prepared to marry it for what could be a very long time.

 

SD

 

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I work in the commercial banking division of bank admired my most here and Berkshire.

 

Located in a top-10 city, BAC has great market share.  They agent most of the deals, and with most deals involving term debt and a plain-vanilla LOC, the profitability is driven by treasury management (it's a very sticky part of the business).  When I hear about how the banking sector doesn't have a moat, I disagree.  The regionals don't have the TM reach some of the big banks have.

 

I think BAC will continue to do well going forward, Lewis as we know made a lot of dumb mistakes, reversing those mistakes has taken 2 years (going on 3).

 

Much of the talk here is based on valuation, but BAC (the business) still has a great franchise. 

 

Non-core asset divestiture is almost complete, looking forward to Archstone announcement soon.  The legacy 05-07 "bad" assets are almost complete (therefore reserve releases will be a boost).  I think some announcements are in the works re: dividend, repurchase, SIFI surcharge, legal resolution. 

 

Also thought this article was refreshing:

http://www.startribune.com/business/133709738.html

 

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