Warren Buffett bets on a stock the market doesn’t like

The first quarter of the year, Warren Buffett and his company Berkshire Hathaway (BRK.A 0.97%) (BRK.B 0.95%) Bought nearly 9 million shares – roughly 2.9% stake – in the big digital bank Financial Ally (ally 2.68%), which specializes in auto lending. With the inventory challenge continuing and used car prices soaring, the Ally company has thrived, posting solid financial results since the start of the pandemic.

But given its cheap valuation, the market is clearly not buying into the sustainability of Ally’s earnings. Clearly Buffett and the market are at odds here. Who would be right?

Strong auto market led to strong results

When the pandemic first hit in 2020 and shut down large sectors of the economy for months at a time, the roads were really cleaned up as people stayed home. Because of this lack of travel demand, many automakers have slowed their production. But as the economy returned to normal and people started hitting the roads again, the industry faced supply chain issues — particularly around semiconductor chips — that persisted and kept inventory low. This has led to higher car prices across the board, particularly among used cars, which are up nearly 60% compared to 2019.

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This dynamic was good for the Ally car business. At the end of the second quarter, Ally had more than $82 billion in auto loans to individuals, up $9.5 billion from the second quarter of 2019 and $6.4 billion year-over-year. Meanwhile, the average portfolio return on retail loans was 6.85%, up 10 basis points (0.10%) from the first quarter of the year. This helped Ally generate a base return of 23.2% on tangible common stock in the second quarter.

The strength apparently continued into the third quarter, according to Ally’s chief financial officer, Jane Laclerc, who said prices continued to increase. Auto loan returns to individuals in the second quarter were 7.82%, up 75 basis points from the first quarter. Leclerc said the bank is now creating auto loans for individuals at 8% while maintaining its underwriting criteria.

Leclerc said the company still believes that 4 to 5 million customers are not participating in the auto market due to a lack of inventory. She added that the flow of applications remained strong and that the company did not see significant price sensitivity, especially among wealthier customers.

We’re already seeing a strong influx of application in high-income earners, which we’ve defined as over $50,000. And our average in terms of our client income that we grew up with is over $100,000. So in this segment, with the limitations of the display and our model, we don’t really see that slowdown.

Looming challenges for Ally

Despite the impressive results and strong demand in the near term, investors and analysts fear the time when conditions will return to pre-pandemic levels, which could lead to credit problems, especially given the size of some loans due to high car prices.

During the second quarter, Ally saw the 30-day overdue rate increase from 2.02% to 2.52%. This rate remains below pre-COVID-19 levels and a typical seasonal result in the second quarter. But despite the administration’s assertion that current credit trends are in line with expectations, investors are nonetheless concerned. Management clearly knows the industry and expects used car prices to fall. In their assumptions, Ally is modeling used-car price reductions of 30% from the end of 2021 to 2023.

Given the Federal Reserve’s sharp increase in interest rates in recent months, analysts are concerned about funding costs. Over the years, Ally has already done a great job improving its core deposit base. In 2018, only 64% of its funding base consisted of deposits. At the end of the second quarter of this year, that number had jumped to 85%. But with a total return of 1.16% from the total funding base, Ally’s funding is still less stable and more expensive than many other large banks, which will inevitably lead to higher deposit costs in the near future, given the large increases by the Fed.

Why is Buffett making this bet?

Given that Berkshire only holds 0.1% of its large portfolio, I think Buffett understands that there are risks associated with this bank. But it’s likely a bet that the Oracle of Omaha and Berkshire see as favorable in terms of risk-reward presentation, given Ally’s valuation of the cheap. The stock is trading at five times forward earnings and about 90% of its tangible book value, or net worth.

Ally’s management team recognized the challenges, modeled a significant decline in used car prices, and still believes it can deliver a sustainable return of 16% to 18% or higher on tangible common stock over the medium term. If they achieve this through more difficult economic conditions, the stock is sure to trade higher.

On top of that, Ally has a track record of buying back a lot of stock, and at its current share price, it has an annualized return of 3.4%, two other things that Buffett and Berkshire love.

Ally is an advertising partner for The Ascent, the Motley Fool Company. Bram Berkowitz does not have a position in any of the stocks mentioned. Motley Fool has and recommends positions in Berkshire Hathaway (B stock). Motley Fool recommends the following options: long January 2023 calls of $200 on Berkshire Hathaway (B shares), short January 2023 calls of $200 on Berkshire Hathaway (B shares), and short January 2023 calls of $265 on Berkshire Hathaway (B shares) ). Motley Fool has a disclosure policy.

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