Analytical Wealth

(From Forbes) “Countrywide Financial Corp. said Wednesday that Bank of America Corp. has made an equity investment of $2 billion in the company, a deal that comes as the nation's largest mortgage lender tries to weather a credit crunch that's rocked Wall Street and the mortgage industry

The transaction was completed and funded Wednesday, Countrywide said…
 

… Under the terms of the deal, Charlotte, N.C.-based Bank of America acquired $2 billion in the form of nonvoting, convertible preferred stock yielding 7.25 percent annually, Countrywide said. The shares can be converted into common shares of Countrywide at $18 per share, with certain restrictions… 

… Kenneth D. Lewis, Bank of America's chairman and CEO, said in the statement that turmoil in the stock market has led some to underestimate the value in Countrywide's operations and assets.

"This investment reflects our confidence in their business and recognizes the importance of the company in providing home financing across the country," Lewis said.”

Whilst the full details of the deal haven’t been disclosed, it stands to reason that BAC stands to make a HUGE return off of this investment. At the time the deal was announced, the stock was trading at about $21.80, a 21.11% premium over the strike price of the convertible shares, and as of the writing of this article (7:19 PM EST – 8/22/07) the stock had risen in after hours trading to $26.60, or a 47.78% premium over the convertible share’s strike price.

If BAC were to convert the preferred shares to common shares in two years, even if the stock remained flat at $26.60, BAC would see roughly $1.25 billion worth of gross profits and a total return of about 62.28% between the yield and the stock’s appreciation. If Countrywide’s stock were to touch the low to mid 40s within the next two years, Bank of America could see nearly $3 billion worth of profits and a ROI of nearly 150%.

This is not to say that this is a “risk free” investment for Bank of America, but the downside in Countrywide is relatively minimal at this point, as the $2 billion should help them make the transition to funding most of their loans through their retail bank, as well as only originating loans that can be sold to either Fannie Mae or Freddie Mac. Additionally, the investment from BAC should go a long way towards restoring investor confidence in Countrywide.

Situations like Bank of America’s investment in Countrywide are why Warren Buffett sees the current market turmoil as an opportunity, because if you make significant investments in the right companies, there is an amazing amount of money to be. Of course, the situation is a bit different for us little guys, as putting Junior’s college money in a beaten down stock isn’t going to move markets and perhaps save the company from bankruptcy. 

However, the situation does provide a clue as what constitutes “true value”. True value isn’t a beaten down financial stock that should survive due its size or because “XYZ lending isn’t going away”; instead, it’s the profitable company that’s suffering more from the state of the credit markets and larger macroeconomic concerns, then from bad business practices. When evaluating a financial stock as a “value investment”, the first question should always be: “Is this company suffering due to bad business practices or from problems with the larger market?”  Remember, one of Warren Buffet’s “value tenets” is to invest in good companies with solid management teams, not just in a company with a “chance”, seemingly low book value or a high analyst target whose stock appears to be on sale.

Disclosure: the Author doesn’t own positions in either Bank of America, Berkshire Hathaway or Countrywide