The Power of the Capital One Stock Buyback

Some investors love them, others hate them, but regardless of which camp you find yourself in, the reality is that share buybacks have an ability to boost shareholder value significantly. The news out of Capital One Financial (COF) last week hardly got any attention, but I wanted to point it out in the face of all the negativity surrounding the banking sector.

Despite the gloom and doom forecasts that the U.S. consumer is dead and everybody is facing home foreclosure and default on their credit card and student loan debt (exaggeration intended), Capital One announced a $2 billion share buyback and a dividend increase of 1,289% (to $1.50 per share annually). One has to think the COF board thought long and hard before increasing the company's annual dividend from 0.2% to 3%. If there was any reasonable chance of a capital shortfall in the future, they would have surely treaded more slowly. The only thing worse than cutting your dividend is doing so only months after initiating one (the prior $0.11 annual dividend was immaterial).

At the beginning of 2007, a $2 billion buyback would have only retired 6% of COF's shares, but today it represents 11% of the company (nothing to sneeze at). How much of an impact can a buyback like this really have in such a negative environment for financial stocks? Isn't news of a buyback irrelevant when we are facing the increasing loan losses in 2008?

You might be quick to answer "yes" but looking back at 2007, it appears that the 38% drop in Capital One's stock was severely overdone. How can that be? Believe it or not, Capital One's book value per share rose by 1% during 2007. An even more important metric, net tangible assets per share (book value excluding goodwill), rose by 9% during 2007. This was due to a combination of large stock buybacks and lower than anticipated deterioration in Capital One's asset base.

As the data I have compiled here on COF shows, there is plenty of value in the financial services sector, despite almost constant fear that the financial services industry in our country is falling apart.

Below are Capital One's shareholder metrics for the twelve months ended 12/31/07. Similar numbers in 2008 would not surprise me, although most of Wall Street seems to think otherwise.

Full Disclosure: Long shares of Capital One at the time of writing

JPMorgan Chase Shines In Otherwise Ugly Financial Sector

Of course, a shining performance is all relative when we are talking about the banking sector right now, but still, JPMorgan Chase (JPM) has really navigated this rough environment well so far. I don't own the stock, but certainly wouldn't mind being a shareholder right now. This morning the company reported that 2007 earnings rose 15% to $4.38 per share. Fourth quarter numbers were down sharply, not surprisingly, but overall the company is faring much better than competitors like Citigroup (C).

Not only does JPM have much less CDO and sub-prime mortgage exposure, but their credit card portfolio is holding up very well too. Their credit standards clearly have been more conservative than other players. For the fourth quarter, card delinquencies reached 3.5%, up from 3.1% in the prior year, and net charge-offs were 3.9%, versus 3.5% in 2006. While these figures did rise year-over-year, they remain very low for the industry, where many are reporting figures above 5% in recent months.

JPMorgan's management team, as well as their shareholders for betting on CEO Jamie Dimon, should be congratulated for posting a 15% increase in 2007 earnings per share. There are few banks out there that will be able to claim that feat when earnings season is over later this month. The stock, meanwhile, yields nearly 4% and trades at less than 10 times earnings. The shares will likely continue to outperform their peers going forward.

Full Disclosure: No position in C or JPM at the time of writing

BAC/CFC Baseball Analogy

Sometimes baseball analogies work as well as anything to help explain something. With Bank of America (BAC) buying Countrywide (CFC) for $6.1 billion ($4.1 billion in stock plus the $2 billion in cash they invested last year), one came to mind. I think this is a lot like when a major league pitcher hurts his arm badly and elects to have "Tommy John" surgery. You have to sit out a full year, but the club is banking that an extended period of time off will result in maximum recovery, resulting in the player pitching like this old self when he returns the following year. You sacrifice the near-term in order to maximize long term upside potential.

Bank of America was already the largest mortgage player among the big diversified banks. Adding Countrywide (the largest independent mortgage company) makes them the Goliath in the industry. In the short term, this will hurt them. More losses, more write-downs, more delinquencies until the cycle hits bottom and stabilizes. It won't be pretty. But when the cycle does turn, losses have largely been absorbed, and we (hopefully) get back to a time when you put money down and get a fixed rate mortgage to buy a home, the BAC/CFC combo could be a home run.

To put the purchase price of $6 billion in perspective, Countrywide earned between $2.2 billion and $2.7 billion in profit every year between 2003 and 2006. Obviously the later years were more "bubbly" in nature, but if you look out several years, when the overall mortgage market will be larger in volume terms (despite lower margins most likely as ARMs dissipate), the CFC deal could easily add $2 billion in annual profit to BAC's business after you factor in cost savings from the merger and cross-selling to a new customer base. That puts BAC's cost basis at 3x earnings, even after factoring in the $2 billion convertible preferred investment last year. Clearly that is what Bank of America CEO Ken Lewis is banking on, pun intended.

Full Disclosure: Long shares of Bank of America at the time of writing

Barron's Pans Buffett's Berkshire

When I heard the media reporting that the Barron's cover story this weekend was a piece warning investors that shares of Berkshire Hathaway (BRKA) were overvalued, I was both surprised and in agreement. I think many publications would avoid panning Berkshire's investment merits, even if they believe the stock to be too high, just because we are talking about the greatest investor who has ever lived. On the other hand, the case that BRK is overvalued is pretty strong, so from that standpoint, Barron's might be doing investors a favor by pointing it out.

I didn't read the full article, but the news wires are reporting that Barron's concluded that BRK is about 10% overvalued at current levels. I decided to take a quick look at the stock's valuation to see if I agreed with that. I was already aware that Berkshire's P/E was well above 20, which is why I do not own any shares in the company, but at that same time, one could surely argue that most of Berkshire's value should not be measured using a P/E ratio. As a result, I did some quick number crunching using book value rather than earnings per share.

The reason for using book value is quite simple. A majority of Berkshire's net worth comes from stock holdings in public companies as well as operating businesses (from which most of the net income is derived from the insurance business). Insurance companies are valued using price-to-book ratios (typically they garner a ratio slightly above one) and common stock investments can be valued easily using current market values.

As of September 30th, Berkshire's book value was $120 billion. Of this, more than half ($66 billion) lies in the company's stock holdings. That leaves $54 billion in book value from Berkshire's operating businesses. If they were solely in the insurance business, I might assign a price-to-book value of somewhere around 1.2x to them, but Berkshire is more than just insurance. As a result, you could conclude that Berkshire's operations should be valued at two times book, so let's use that number.

Quick math nets us a value for Berkshire of $174 billion (2 x $54b + $66b). At Berkshire's current quote of $137,000 per share, that would make BRK about 18% overvalued, even more than the Barron's estimate. Buffett clearly is worth a premium for most investors, but at the very least, Berkshire stock hardly looks like a bargain after a huge move upward in recent months.

Full Disclosure: No position in Berkshire Hathaway at the time of writing

U.S. Bancorp Raises Dividend by 6%

That is not a misprint. There are banks in this country that are raising their dividends. U.S. Bancorp (USB) now yields more than 5% on the new annual payout of $1.70 per share. The lack of worry on their part stems from a very conservative business model. They are simply content growing at a slower rate, and avoiding aggressive lending practices, as opposed to the strategies that other large banks have adopted in recent years. This is evident from USB's press release, which points out the company has raised its dividend for 36 straight years, and has paid one in 145 consecutive years.

If you are looking for a high yielding, lower risk bank stock, USB is a solid option in the second tier of companies (large banks, but not the giant banks). Warren Buffett recently upped his stake in the firm, so he obviously likes management here quite a bit. The stock isn't dirt cheap at 12 times forward earnings and about 3 times book value, but sometimes you have to pay a bit more for safety, and the stock certainly is not overpriced by any means. Take a look at it if you want to venture outside the Big 3 in domestic banking.

Full Disclosure: No position in USB at the time of writing

Keep Money Market Fund Worries in Perspective

The media tends to over-hype news. Things are presented as better than they really are in good times and worse than reality in bad times. Recent worries about money market funds that have invested in subprime mortgage-backed securities are just one example. There has been speculation that small investors face the possibility of losing significant amounts of money in their money market investments, despite the appearance of such funds as being very low risk in nature.

Yesterday we learned that in fact Bank of America (BAC) was shutting down a $34 billion money market fund. The headlines were grim, but once one actually reads the facts of the situation, it is apparent that it is no big deal at all.

First of all, the fund in question is not a typical money market fund. It was an "enhanced" fund that knowingly took on more risk than the average money fund, hence the subprime exposure. As a result, only institutions were allowed to invest (since they understood the risks were greater) and the minimum investment was $25 million, so individual investors are not exposed.

Secondly, and more importantly, the losses the fund sustained before being shut down by BofA were barely noticeable. Investors in the fund were able to redeem their shares at a rate of 99.4 cents on the dollar. That's right, despite the gloomy headlines in the media, investors in this risky fund lost less than 1 percent of their original investment. And this fund was risky!

So for all of you out there who are spooked about money market funds, perhaps this data point can ease your concerns.

Full Disclosure: Long shares of Bank of America at the time of writing

Forget Writedowns, Bank of America Gets $16B Writeup!

From the Financial Times:

BofA set to gain $30bn on CCB stake

Tuesday Nov 13 2007

Bank of America (BAC) on Tuesday said it was sitting on a potential gain of more than $30bn on its investment in China Construction Bank, highlighting the paper profits some western banks have made on holdings in their Chinese counterparts.

BofA paid $3bn two years ago for an 8.5 per cent stake in CCB and an option to increase to 19.9 per cent at a very low price. The bank plans to record a gain of about $16bn on its existing stake in the fourth quarter.

"On paper we have a potential gain in excess of $30bn," said Joe Price, BofA's chief financial officer, adding that it would be able to cash in some of its holding over the next 2 to 3 years.

Not only does BofA have less subprime mortgage and MBS CDO exposure than other big banks, but they also have done some smart things which will certainly help them weather the storm.

Full Disclosure: Long shares of Bank of America at the time of writing

Countrywide Predicts Trough, Shares Soar 24%

Gauging the outlook for pure mortgage lenders like Countrywide (CFC) is a tough game and one that I am choosing not to play. The company is predicting that the third quarter was the trough and profits will return in Q4 and 2008, but nobody really knows for sure. Delinquency rates are still rising at CFC, standing at 7.1% as of September 30th, up from 5.7% three months before.

Until there are signs of stability and that stability hangs around for a while, I'm not going to bottom fish in mortgage-related companies like pure lenders or mortgage insurers. Honestly, those stocks are down so much, trading far below even recently slashed book values, that I think eventually there will be plenty of upside without even needing to time the bottom of the cycle.

Until then, I continue to like the bigger diversified banks with fat dividend yields. With these stocks yielding more than treasury bonds, I think you can justify buying low and being patient, knowing that calling a bottom is essentially impossible. I would, however, start making a list of the kinds of stocks you might want to target when things start to rebound. You won't be able to time a purchase perfectly, but there is no way that most of the home builders, mortgage insurers, and big lenders won't survive and be consistently profitable when the markets get back to some sort of more typical environment.

There will be money to be made, but I'm not comfortable jumping into pure plays just yet. Hopefully by sometime in 2008 things will stabilize and we'll have a better idea of what "normal" conditions look like. At that point, making bets will be much more prudent.

Full Disclosure: No position in Countrywide at the time of writing

A Trade Idea As Another Bank of America Entry Point Presents Itself

On July 30th I mentioned how I thought Bank of America (BAC) stock at $47 was attractive with a 5.4% dividend yield. The shares moved above $52 since that post, but today are falling back sharply, to $48 each, after the company posted poor third quarter results, just like every other bank has thus far. The dividend now stands at 5.3%, and I think it is very safe.

If you want to generate even more income on this trade, you could buy the stock to collect the dividend and any capital appreciation, while simultaneously selling out of the money call options on the shares to collect more cash. For example, the May 2008 52.5 calls are selling for about $1.75 each right now. Buying the stock and selling those calls would result in a breakeven point of ~$45 per share over the next 7 months or so. Conversely, your upside would be up to $52.50 on BAC stock, plus dividends and option premiums of around $3 per share (up to 15% in total gains).

If you think the stock will trade within the recent range of the high 40's to low 50's, this trade would be a great way to make a double digit percentage profit if BAC can make up the few points of recent losses in coming months.

Full Disclosure: Long Bank of America at the time of writing

Banks Announce Major Writedowns? Duh!

That's not even really my headline. It's what the market is saying this morning after both Citigroup (C) and UBS (UBS) announced huge losses during the third quarter. Citi plans to take $3.3 billion in write-downs for the quarter, consisting of $1.4 billion from LBO loan commitments, $1.3 billion from losses on sub-prime securities, and $600 million from fixed income trading losses. Also hitting the wires today was news that UBS is projecting a quarterly loss of up to $690 million.

So the market's getting crushed, right? Well, not exactly. Citi stock is up 1 percent, with UBS up 4 percent. The Dow is higher by more than 100 points, and once again sits above the 14,000 level. Now, I am not telling you this as a proclamation that the worst is over and we are off to the races. I don't know when the credit losses will peak, and there will be more write-downs in the future, even additional adjustments from Citi and UBS.

The takeaway from this morning's action is that everyone and their grandmother knew these write-downs were coming. The stocks have been hammered because of that. The rallies today should not be that surprising as a result. It represents a relief rally because, at least for now, the losses aren't as bad as they could have been. That doesn't mean things won't get worse, it just means that, for now, the world is not ending.

Full Disclosure: No positions in the companies mentioned at the time of writing