Will Bank of America Become a Warren Buffett Stock in 2017?

5/9/17

By Matthew Frankel, MotleyFool

In the wake of the financial crisis, Warren Buffett invested $5 billion of Berkshire Hathaway's (NYSE:BRK-A) (NYSE:BRK-B) capital in Bank of America (NYSE:BAC) preferred stock, a deal which also gave the company a warrant to purchase 700 million shares of the bank's common stock at any time before mid-2021.

At Berkshire's annual shareholder meeting on May 6, Buffett was asked whether or not Berkshire planned to exercise its warrant and add Bank of America stock to its portfolio. Here are the details of Buffett's Bank of America investment, and what he had to say about his company's investment.

Warren Buffett at Berkshire Hathaway's annual meeting.

IMAGE SOURCE: THE MOTLEY FOOL.

Buffett's Bank of America investment

In August 2011, Buffett decided to purchase $5 billion in Bank of America preferred stock, which paid an annual dividend yield of 6%. However, the sweetest part of the deal turned out to be a warrant to buy 700 million shares of Bank of America's common stock for $7.14 each until September 2021.

Now, this didn't seem like a tremendous deal at the time, since the warrant's exercise price was roughly identical to the bank's stock price in August 2011, giving the warrant no immediate intrinsic value. However, the bank's share price has more than tripled since then, making the warrant worth $11.8 billion as of this writing. In fact, if we include the value of the preferred stock and the dividends Berkshire has been paid so far, Buffett's original $5 billion investment is worth $18.3 billion today:

BAC Chart

BAC STOCK-PRICE DATA BY YCHARTS.

Will Berkshire exercise its warrant?

When asked whether Berkshire would exercise its B of A warrant, Buffett essentially said that wasn't even up for debate. Since the warrant allows Berkshire to buy Bank of America stock for less than one-third of its current share price, it would be silly not to exercise it. Not doing so would leave $11.8 billion on the table, based on the bank's current stock price.

The real questions are:

1. When will Berkshire exercise its warrant?

2. Will the bank hold on to its shares after the warrant is exercised?

When will Berkshire exercise its warrant?

This is the easier of the two questions to answer, as Buffett addressed this specific issue in his latest letter to Berkshire's shareholders. The timing of the warrant exercise depends on what happens with Bank of America's dividend over the next few years.

Since Berkshire's Bank of America preferred stock pays $300 million per year, and Buffett has mentioned that Berkshire could (and likely will) use its preferred shares to pay the cost of exercising the warrant, Bank of America's dividend would need to replace that lost income to justify an early exercise.

Doing the math: In order for 700 million shares of Bank of America to generate over $300 million in income, the bank would need to raise its dividend to $0.44 per share. Currently, the bank pays just $0.30 per share. So, if the dividend is raised to $0.44 or higher, Berkshire would likely exercise its warrant well before expiration.

On the other hand, if the bank's dividend remains below this threshold, Buffett would exercise the warrant just before it expires.

With the annual review of Bank of America's capital plan due in a couple of months, keep in mind that a $0.44 dividend is the magic number that could determine whether Berkshire will buy Bank of America stock in 2017.

Will Bank of America remain a Buffett stock after the warrant is exercised?

This is the tougher question, simply because we don't know when the warrant will be exercised. And if a significant amount of time passes before it happens, there's simply no telling what could happen to Bank of America, or the banking business as a whole, between now and then.

At Berkshire's meeting, Buffett did say "we would keep the stock" if the warrant were to expire, or get exercised today. Buffett commented in his letter that he's a fan of Bank of America's aggressive share repurchases while the stock is undervalued. It's fair to assume that if he still perceives Bank of America to be fairly valued at the time of the warrant's exercise, it could become the newest addition to the bank stocks already in Berkshire's portfolio.

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