In the first quarter of the year, Warren Buffett and his company Berkshire Hathaway initiated a small stake in digital consumer banking Allied Financial (ALLY -3.14%), which is also a major auto lender. In the second quarter of the year, Berkshire more than tripled its equity position, buying more than 21 million shares during the quarter. Now, Berkshire’s position in Ally stands at 30 million shares valued at more than $1 billion, representing almost 9% of the company. With Buffett and Berkshire buying big now, is Ally a buy? We’ll take a look.
Wall Street has gone bearish
Interestingly, Buffett is piling into Ally as the street becomes increasingly bearish. After a strong second-quarter earnings report, a number of analysts downgraded the stock due to funding and credit quality concerns.
Ally has been bolstered in recent years by a shortage of car inventory and high car prices and interest rates, which have boosted financial results. Ally’s retail auto loan portfolio at the end of the second quarter reached more than $82 billion, up 8.4% year-over-year. As the Federal Reserve raised interest rates, margins also increased significantly.
This helped Ally generate a base return on tangible common equity (ROTCE) of over 23% in the second quarter, which is stunning. Additionally, management said on Ally’s second-quarter earnings call that it originated auto loans at an 8% yield in the third quarter while maintaining its underwriting standards.
But analysts worry about what will happen when car prices normalize and how consumers will fare now that stimulus programs have ended and economic conditions are tougher. In the second quarter, Ally saw 30-day overdue payments in its automotive retail portfolio jump 0.50%. Also in the quarter, Ally began to see its deposit costs climb, which will continue to rise this year along with interest rates and may begin to squeeze the bank’s margins.
Why is Buffett buying?
Let’s remember a few things when we talk about Buffett and Berkshire’s investment philosophy: they both like to invest for the long term, and they both know the automotive sector quite well.
Berkshire first invested in General Motors (GM 2.53%) in 2012, although he actually reduced his position in the company in the second quarter. Ally was a financing division of GM called General Motors Acceptance Corporation until 2006 when GM sold a majority stake in the company. Eventually, General Motors Acceptance Corporation would apply for a bank charter and rename itself Ally.
Ally’s management team appears prepared for auto prices to normalize and said it assumed used car prices, which have risen 60% since 2019, will drop 30% between the end of 2021 and 2023. The bank also reserves for future losses cautiously considering that it does not yet see huge cracks in credit quality.
Additionally, Ally has also done a much better job of improving its funding base and customer relationships. In 2018, only 64% of its funding base came from deposits. Now more than 85% of its funding comes from deposits. In addition, Ally now offers mortgages, credit cards, point-of-sale loans, and wealth management, all of which can help create better consumer relationships and hopefully lead to more relationships. primary banks and a higher quality deposit base. Ally’s deposit fees are still quite high compared to other big banks, but it looks like the company has really improved that aspect of the business and can continue to do so.
Finally, Ally believes her returns will continue to be higher post-pandemic. Before the pandemic, the company would generate at best a ROTCE of 12%. Now, management has guided for a ROTCE of 16% to 18% in 2022 and over a medium-term time horizon.
A value game for Buffett
Buffett and Berkshire have long been value investors, and Ally gives them the opportunity to buy an asset they believe is trading at less than fair value. Ally is currently trading at around 105% of its tangible book value or net worth, and around five times forward earnings.
Companies generating and guiding the kind of returns that Ally is normally trade at a much higher valuation, so the market is clearly skeptical of the sustainability of returns. But Buffett and Berkshire clearly like the risk-reward setup here, which I think is favorable given Ally’s low valuation. Ally also pays an annual dividend yield of over 3% and buys back a lot of stocks, two other things Berkshire and Buffett find attractive. Overall, I agree with Buffett and Berkshire and think Ally is a buy at those levels.
Ally is an advertising partner of The Ascent, a Motley Fool company. Bram Berkowitz has no position in the stocks mentioned. The Motley Fool holds positions and recommends Berkshire Hathaway (B shares). The Motley Fool recommends the following options: $200 long calls in January 2023 on Berkshire Hathaway (B shares), $200 short puts in January 2023 on Berkshire Hathaway (B shares) and short calls of $265 in January 2023 on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.