Warren Buffett and his investing team at Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) have now made not one, not two, but three big investments in Bank of America (NYSE: BAC). First, Buffett purchased more than $800 million worth of shares at prices ranging from roughly $23.51 to $24.23 per share. A few days later, he and the company bought another $400 million worth of shares at prices ranging from roughly $24.10 to $24.30. Last week, Buffett struck again, purchasing another $522 million worth of shares at prices ranging from roughly $24.32 to $25.24.
In just two weeks, the Oracle of Omaha and Berkshire Hathaway collectively invested $1.7 billion, purchasing 71.6 million shares in America's second-largest bank by assets. Berkshire now owns more than 1 billion shares of Bank of America and 11.8% of total outstanding shares, making it the company's second-largest holding behind Apple.
Needless to say, Buffett is bullish on Bank of America. I obviously can't read his mind, but one reason I think he may like Bank of America is because of the company's strong capital position and safe dividend long term. Let's dig into both.
A strong capital position and a safe dividend
There's a good chance Buffett increased his stake in many of his bank holdings in the second quarter, after seeing many large banks set aside billions to cover potential loan losses and still turn a decent profit. But we know Buffett took a fairly cautious approach in the early months of the pandemic, building up $138 billion in cash and liquid securities. Additionally, the one bank Berkshire dumped most of its stake in was investment bank Goldman Sachs (NYSE: GS). While Goldman had a good second quarter, it's slightly riskier than other large banks -- during the Federal Reserve's annual stress testing, Goldman saw its capital ratios fall much more than most peers' in a hypothetical adverse scenario.
In the same stress test, Bank of America maintained strong capital ratios and took fewer loan losses than many of its peers. The bank is also very well positioned in its current situation.
Banks operate under strict capital requirements, and a number closely watched by regulators is the common equity tier 1 (CET1) capital ratio, a measure of a bank's core capital expressed as a percentage of its risk-weighted assets. Each bank has a required minimum threshold based on the composition of the company and the particular assets it holds. Currently, the Fed is restricting dividends to an amount not higher than a bank's average net income over the last four quarters. But under normal circumstances, if a bank's CET1 ratio falls below its required threshold, limits on capital distributions come into place, and at that point banks must seriously consider making a dividend cut.
Bank of America's required CET1 ratio is 9.5%, but its current CET1 ratio at the end of the second quarter is 11.6%, leaving it with 2.1 percentage points to fall before it hits that threshold -- which is a lot of room. Bank of America's CFO, Paul Donofrio, said on the company's recentearnings callthat "the capital cushion above our 9.5% CET1 minimum was $28 billion at quarter end." That's after the company has already set aside close to $10 billion to cover potential loan losses in the first and second quarters of the year. In comparison, Citigroup had 1.5 percentage points to fall before hitting its threshold; JPMorgan Chase only had 1.1 points before hitting that threshold; and Wells Fargo has already cut its dividend by nearly 80%, although for different reasons.
Additionally, Bank of America executives said that in the one of the Fed's stress-testing scenarios, the bank took losses of around 4.7% or slightly more of its total loan book. The bank already has a little less than half of that amount set aside in reserves. And remember, these are projections, and these losses have not even really begun to materialize yet. Further, the bank could absorb tens of billions of dollars more in losses beyond what it has already set aside and still maintain a strong capital position. Executives said that even if the bank did need to set aside enough reserves to cover losses amounting to 4.7% of the total loan book, its total CET1 ratio would still only fall to 10.25%, still solidly above its required threshold.
Obviously, we still don't know how bad things could get, but Bank of America seems to be thinking conservatively. Behind its modeling, CEO Brian Moynihan said the bank is assuming that unemployment will end the year around 10% and remain at 9% in the first half of 2021, with total GDP not returning to pre-coronavirus levels until late 2022 or early 2023.
A conservative play with upside
I recently wrote that Bank of America does not excite me as much as a big bank like JPMorgan Chase. That's because JPMorgan managed to generate record revenue of $33.8 billion in the second quarter to offset its biggest-ever quarterly credit provision of $10.5 billion. That wowed me, and I believe a lot of other investors were impressed at JPMorgan's ability to continue to turn a solid profit amid such difficult economic conditions.
But Bank of America still turned a decent profit considering its quarterly credit provisions, and it's consistently generating enough revenue and has a strong enough capital cushion to protect its dividend for sustained periods of difficult economic conditions. This should be attractive to Buffett, who we know loves dividends.
At the low end of Buffett's recent purchase of Bank of America ($23.51), the stock was trading at 84% of book value. At the high end ($25.24), Bank of America was trading at about 90% of book value. This leaves plenty of opportunity for Berkshire to generate a potentially great return if the bank can escape the pandemic in a position similar to what it enjoys now.
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Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple and Berkshire Hathaway (B shares) and recommends the following options: short September 2020 $200 calls on Berkshire Hathaway (B shares), long January 2021 $200 calls on Berkshire Hathaway (B shares), and short January 2021 $200 puts on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.
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