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Warren Buffett got the best deal on Bank of America stock, and investors who bought in at its 52-week lows earlier this week will make out well. Yet there's still room, even after the Buffett bounce, for investors to ride the B of A rebound.

Canadians, used to a handful of large coast-to-coast financial players, may not appreciate that the United States has never had a truly national bank. Bank of America, which rose from its North Carolina roots to hold nearly $1-trillion (U.S.) in deposits and operate almost 6,000 branches, has arguably come closest.

It is also the last of the major U.S. banks with a serious overhang from the past financial crisis; the company's drive to be big in everything it did led to an ill-timed acquisition of mortgage lender Countrywide Financial.

The likelihood of continued housing weakness, and unknown continuing legal liabilities for mortgage misdeeds, made investors wary that B of A would have to raise a significant amount of highly dilutive capital. And, as the shares fell on those concerns, any future raising of capital would be even more dilutive, as more shares would be required to raise the same amount of money.

Mr. Buffett's move, made through his investment vehicle Berkshire Hathaway on Thursday morning, is the typical sweet deal that only he can make. For $5-billion, Mr. Buffett gets preferred stock with an annual 6-per-cent dividend (B of A common shares currently yield just 0.6 per cent). He also gets warrants to buy 700 million common shares of B of A – about 6.5 per cent of the company – at any time in the next 10 years for about $7.14 apiece.



"While some investors may be left wondering what exactly does a $5-billion investment do for a company with a $2.3-trillion balance sheet, we cannot emphasize enough that this sector is all about market confidence," says Société Générale credit analyst John Guarnera. "This announcement, and the fact that it came from Berkshire, provides a huge dose of confidence for investors at a time [that]the company desperately needed it."

(Disclosure: I own 400 shares of Berkshire's class B stock in a retirement account, making it my single-largest holding.)

Indeed, the Buffett move does not make a huge contribution to the bank's capital, but there's an argument to be made that CEO Brian Moynihan was right when he said repeatedly in recent weeks that B of A doesn't need a massive influx of cash.

Guggenheim Securities LLC analyst Marty Mosby points out that B of A's tangible book value was roughly $12.65 a share at quarter's end. Assuming the company needs $25-billion to settle the mortgage issues, Mr. Mosby says, tangible book would drop to about $11 a share – which would still be more than 40 per cent above the current share price. (Mr. Mosby has a "buy" rating and uses $11 as a target price, believing B of A should trade at, not at a significant discount to, tangible book value.)

What if $25-billion is too small an estimate? John Hempton, an Australian money manager who owns B of A stock for himself and his clients, blogged this week that even if the financial services giant needed $70-billion to work its way out of its mortgage mess, those costs can be dragged out over the course of multiyear litigation and therefore won't cause the company to dip below levels of capital preferred by regulators.

B of A's capital ratio, at 8.2 per cent, has increased 3.75 percentage points since the beginning of 2009, notes Moshe Orenbuch of Credit Suisse. With several years of annual earnings of $20-billion or more, he foresees a near-doubling of this key industry benchmark by 2018, including the negative impact of new, more restrictive rules for its calculation.

B of A, Mr. Orenbuch says, "remains the cheapest bank in our coverage universe" with shares trading at about five times 2012 earnings, versus the large-capitalization peer average of seven times, and at 0.6 times tangible book value, versus peers at 1.1 times book.

"We think pressure on the shares is overdone," Mr. Orenbuch said, as "shares have not traded at these levels since March, 2009, despite the fact that risk has been reduced materially."

B of A's market cap is now about $80-billion, half what it was at the beginning of the year. For that price, you can get a global investment bank, a nationwide brokerage network, thanks to B of A's 2008 purchase of Merrill Lynch, and a gigantic issuer of credit cards and mortgages. All told, B of A estimates it has 57 million U.S. customer relationships, and it has a top-five presence in all of the 30 biggest U.S. markets.

Mr. Buffett has a reputation for taking a long-term view and embracing valuable franchises when they fall out of favour. With the shares closing Thursday at $7.65, a modest 9.4-per-cent gain on the news of his investment, B of A shares are priced for continued risk – allowing for a significant reward for both you and Mr. Buffett.



Special to The Globe and Mail

Editor's note: An earlier version of this story incorrectly stated that Warren Buffett's warrants to buy 700 million common shares of Bank of America would amount to a little less than 1 per cent of the company. This online version has been corrected.

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