Back in August of 2011, Warren Buffett took total advantage of Bank of America’s (NYSE:BAC) temporary troubles by offering to buy $5 billion of newly issued preferred stock. In exchange he received a 6% annual dividend, an agreement to be paid a 5% premium to have his shares redeemed, and warrants to buy 700 million shares at $7.14 per share, which was the price of the stock that day.
At the time, Bank of America was recovering from a crisis. They had lost tens of billions of dollars from the disastrous purchase of Countrywide Home Loans. The dividend was reduced to one penny per share and new BASEL III standards were requiring Bank of America to build capital to fortify the balance sheet. Warren Buffett offering to invest $5 billion in Bank of America was a welcome infusion of capital and confidence for the company, but it came with an onerous price tag that infuriated me and many other shareholders who were correctly betting that the company was going to be just fine on its own.
The damage was done back in 2011 when the deal was announced, but the true price has yet to be paid. The 700 million warrants Berkshire Hathaway (NYSE:BRK-A) were given are exercisable any time in the ten years following the deal. We are now six years into the warrants and Warren Buffett has a paper profit of over $11.1 billion on his warrants, which he received for free. When these warrants are exercised, Bank of America will sell 700 million shares to Berkshire Hathaway for $7.14 each. They will receive $5 billion cash, which will increase shareholder equity by $5 billion. The dilution however, will negatively impact per share book value. If the warrants were exercised today, the impact would be a reduction in book value of $1.13 per share, or a little less than 5%.
That unnecessary hit to book value is only part of the problem. The other part comes when you realize that Bank of America has just spent the last four years reducing the share count by 800 million shares. The 700 million warrants if exercised today would take us backwards almost to square one on cleaning up the massive dilution shareholders have had to endure.
By no means am I claiming Bank of America is a bad investment. I have owned this stock as a core position since 2009. It needs to be understood however, that the long-term buyers of the stock today are going to be the ones who ultimately pay the price to Uncle Warren when he decides to exercise those 700 million warrants. They will be the ones who watch tens of billions of dollars of profit siphoned off to repurchase the shares which now trade around $23 per share and perhaps will trade even higher in the future. Bank of America will also have to pay the dividend on the newly issued 700 million shares, further reducing the capital available to the rest of the shareholders.
My recommendation to shareholders today would be to sell upside calls on this stock. The easy money has already been made here. The stock, with 10 billion shares outstanding, will struggle to rise meaningfully from here as each penny increase in share price will add $100 million to the market value of the stock. If an investor today opened a position with a buy-write, selling the January 2019, $30 call for $100 per contract, they would collect a minimum of 6.6% in cash from a combination of the option premium plus dividends this year and next. They would have upside of 30%, giving the opportunity to earn over 36.6% in just twenty-one months. $30 would make for a nice exit here as Bank of America would have a market value well over $300 billion with Berkshire Hathaway’s warrants included in the share count. Seasoned investors know that with a market value of that size, it becomes quite difficult to move a stock meaningfully higher.
Warren Buffett may very well be the most street smart hustler that Wall Street has ever seen, and Bank of America certainly got the short end of the stick on their 2011 investment with him. Bank of America shareholders have done very well regardless as the stock was trading at an absurdly low level at the time. Today’s shareholders are not so lucky however, and even though Bank of America is a decent value in today’s market, the upside is going to get much harder from here simply because of the size of the share count, which will grow by 700 million shares at some point in the next few years. Do yourself a favor and accept reality and sell upside calls and enjoy the free money.
Disclosure: I am/we are long BAC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.