Did Warren Buffett Make a Bad Call on Bank of America?

Warren Buffett
Warren Buffett

When Warren Buffett announced in August that he would spend $5 billion to snap up Bank of America (BAC) shares, investors cheered. Surely this must mean that we've seen the end of the bad news from America's biggest bank, right?

And at first, that's exactly what it looked like when, on a day when the Dow Jones Industrial Average sank 1.5%, Bank of America shares surged 26% in response to Buffett's move.

But it didn't take long for the enthusiasm to wear off -- less than a day, in fact.

A Buy Gone Bad

Priced at $6.99 a share on Aug. 24, just before Buffett announced his buy-in, Bank of America stock ended a frenzied day of trading just 9% higher. Worse, over the ensuing month, while the price of shares bounced around quite a bit, they ultimately lost all their gains and ended up right back where they started.

On Sept. 19, Bank of America shares were once again changing hands for $6.99 ... and it's been all downhill since. In fact, earlier this week the company's shares dropped with a thump to their lowest closing price since the days of the financial crisis. When shares dipped below $5 per stub the other day, the big bank was reduced to "penny stock" status, as they say in Wall Street parlance.

What Went Wrong? Everything

How has Bank of America reached this sad state? Let us count the ways.

  • Bad press: Bank of America is a leading candidate for lawsuits whenever homebuyers look for someone to blame when their mortgages go sour. Indeed, the company basically made itself Public Enemy No. 1 when it absorbed Countrywide Financial, once America's leading provider of home mortgages, and a company infamous for shoddy loan practices in the subprime market.

  • Public pressure: The bank's also under constant pressure from the government to boost its assets, keep more cash on hand, and shore up its ability to survive another financial crisis -- but at the same time, it's urged to increase lending to consumers.

  • Even more bad press: It's laying off 30,000 workers.

  • Bad timing: The company is planning asset sales to raise capital to keep the regulators happy ... and just found itself downgraded by Standard & Poor's.

  • Bad exposure: Meanwhile, no one's quite sure how much exposure it has to the ongoing sovereign-debt crisis in Europe.

Basically, if you can think of something bad that could conceivably happen to a hypothetical big bank, then either investors worry it will soon happen to Bank of America or else it already has.

Did Buffett Goof?

Little wonder, then, that since Buffett made his buy-in, Bank of America shares have not performed as predicted. Rather than rising in value, as the investing guru's fans had thought likely, B of A shares have lost nearly 30% of their value.

Ah, well. Misery loves company, right? If mom-and-pop investors lost their shirts on this one, at least they can take comfort in knowing that Buffett feels their pain. And at least they can rest easy knowing that, as bad as things may look, if Buffett hasn't sold his B of A shares yet, then they're bound to go up eventually.

Everybody else should just stick around and wait for the inevitable recovery, right? Right?


Teflon Buffett

Warren Buffett
Warren Buffett

The truth is that Buffett is not in the same boat as the rest of us. To the contrary, while we frantically paddle along in our canoes, he's lounging aboard another yacht entirely.

When the Oracle of Omaha bought Bank of America shares, he didn't take the same risks you or I do when investing in a beaten-down company. Buffett, you see, is not a common investor, and he didn't buy common stock.

Instead, Buffett bought preferred stock. It's a special kind of equity, resembling debt in some ways and common stock in others. On the debt side of the equation, Buffett collects a fat 6% preferred dividend on his $5 billion investment annually. (B of A common stock yields less than 1%.) Meanwhile, on the equity side, if his preferred shares rise in price, he gets to reap those benefits, too.

What's more, as part of his investment in Bank of America, Buffett also received stock warrants -- which give him the right to buy (or not buy, if the price isn't right) as many as 700 million common shares at any time in the next 10 years, at a pre-agreed share price of $7.14 per share. When's the last time you bought a stock and the company gave you a coupon good for a big discount on your next share purchase?

One word: never.

That's right, never. And this is because -- and I don't mean to sound harsh here -- you aren't Warren Buffett. You don't have his billions. Consequently, you're unlikely to be able to finagle the kind of fringe benefits Buffett sometimes gets when he invests in a company.

So what's the moral of this story? Getting back to Bank of America, there may be reasons you might want to buy this bank's shares. Buy them because the price of 5 times forward earnings seems cheap to you. Buy them because the shares cost barely a quarter of the bank's book value. Buy them because you think the risk that Europe will go bankrupt, taking Bank of America down with it, is overblown.

Just please don't buy Bank of America because Warren Buffett did. You're not Warren Buffett.

Motley Fool contributor Rich Smith owns no shares of any companies named above , but The Motley Fool owns shares of Bank of America and Motley Fool newsletter services have recommended buying shares of Goldman Sachs.