The Curious Investor

In another move to the portfolio, I picked up shares of Bank of America a few days ago and dropped my position in Aetna. As I mentioned a few weeks back about the shifting outlook in healthcare, Aetna is likely the health insurer in the best shape to weather the storm. That being said, any good investor needs to be able to cut ties with an investment when a better opportunity presents itself.

With shifting risk in the healthcare sector, an Aetna miss would probably portend an additional loss of 10-20% similar to what has happened to WellPoint, Humana, and Coventry. Looking at Bank of America, which I believe has taken much of the hit that they will absorb, seems to have found a bottom at $35 a share which is similar downside risk to Aetna on a nominal basis but with more leniency already built into the Bank of America stock as analyst estimates at Aetna still factor in 10-15% growth whereas analysts are forecasting 30-50% declines in profits at Bank of America.

In addition to providing similar downside risk, Bank of America is offering a 6% dividend (more now) and many more catalysts for growth. First and foremost, Bank of America has made some strong equity investments - notably a $30 billion gain on its equity stake in China Construction Bank and its Visa holding.

These few write-ups aren’t going cushion the blow of trading losses and subprime writedowns. But, the bank claimed in November to only have $13 billion in subprime CDO exposure and $18 billion in total CDO exposure. Granted, its mortgage and lending business could be hurt in a slowdown and the $5 billion trading write down in January was not a good sign for its ability to manage the crisis despite its relatively smaller exposure, but Bank of America is still likely going to be one of the first to flush out its subprime losses and emerge from the current crisis in financials.

Add in the fact that it seems on track to acquiring Countrywide Financial and position itself as far and away the largest mortgage player in the US and Bank of America would seem to be poised for some really impressive earnings once we get through the current market cycle. To put some numbers on this, if we assume that Bank of America and Countrywide can return to 2005 earnings levels of $16 billion and $2 billion respectively. There is a reasonable expectation for the combined company to make $4.05 a share upon a market turn around and this is without factoring in any organic growth. That puts the company’s reasonable valuation at $40.50 minimum.

Assuming an ability to bring earnings back to 2007 levels for Bank of America alone while keeping Countrywide earnings steady at $2 billion, we come out to a rough valuation of $54-$62 given the 10-12 PE range that Bank of America carried prior to the current market crisis. For me, that equates to about 25-44% return on my investment in addition to the annual 6% dividend with a downside risk of 5-10%.

This admittedly could take a while given that the housing market will likely not bottom until the end of this year and a rebound to 2005 levels could take years. But, with data pointing to severe slow down at least and at worst a looming recession, it would seem prudent to reposition Portfolio B with a longer time horizon and with a focus on cash flow from dividends.

I also admit that I may have had an itchy trigger finger on my BAC buy since clearly it may fluctuate here in mid thirties and low forties for quite some time. A buying price in the mid-thirties, assuming the shift in macroeconomic risk going to a slow down/recession as opposed to a collapse of credit markets, would represent to me significant margin of safety given a 1.5-2 year investment horizon and, a more patient and intelligent version of myself, ought to have waited till then to make the purchase rather than at ~$42.

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