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

In 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 — a stake of about 2.9% — in the big digital bank Allied Financial (ALLY 2.68%), specializing in car loans. While stocks are still challenged and used car prices soar, Ally has thrived, delivering strong financial results since the start of the pandemic.

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

A strong automotive market has produced good results

When the pandemic first hit in 2020 and large swaths of the economy shut down for months, the roads really cleared up as people stayed home. Due to this lack of travel demand, many automakers have slowed production. But as the economy normalized and people started to get back on the road, the industry ran into supply chain issues — particularly around semiconductor chips — that persisted and kept the stocks at a low level. This has led to higher car prices across the board, especially among used vehicles, which are up around 60% compared to 2019.

Image source: Motley Fool.

This momentum has been good for Ally’s automotive business. At the end of the second quarter, Ally had more than $82 billion in retail auto loans, up $9.5 billion from the second quarter of 2019 and $6.4 billion year over year. the other. Meanwhile, the average portfolio yield on these retail loans is 6.85%, up 10 basis points (0.10%) from the first quarter of the year. This helped Ally earn a 23.2% base return on tangible common stock in the second quarter.

And the strength apparently continued into the third quarter, according to Ally chief financial officer Jenn LaClair, who said prices continued to rise. Yields at origination on personal auto loans in the second quarter were 7.82%, up 75 basis points from the first quarter. LaClair said the bank is now providing retail auto loans at 8% while maintaining its underwriting criteria.

LaClair said the company still believes there are between 4 and 5 million customers not participating in the auto market due to inventory shortages. She added that the flow of applications has remained strong and the company isn’t seeing much price sensitivity, especially among more affluent customers.

We’re seeing a very strong flow of applications from high-income earners, which we’ve defined as just over $50,000. And our average in terms of revenue from our customers we originate from is over $100,000. So in this segment, with the supply constraints and with our model, we really don’t see that slowing down.

Looming challenges for Ally

Despite strong results and strong near-term demand, investors and analysts fear when conditions will normalize to pre-pandemic levels, which could lead to credit problems, especially given the scale of the crisis. some of the loans due to rising auto prices.

During the second quarter, Ally saw its 30+ day delinquency rate increase from 2.02% to 2.52%. This rate is still below pre-COVID-19 levels and is the result of typical seasonality in the second quarter. But despite management’s assurance that current credit trends are in line with expectations, investors are nonetheless nervous. Management clearly knows the industry and expects used car prices to come down. In their assumptions, Ally models a 30% reduction in used car prices from the end of 2021 to 2023.

Due to the Federal Reserve’s sharp increase in interest rates in recent months, funding costs are another issue that analysts are concerned about. Over the years, Ally has actually done a great job of improving its core repository base. In 2018, only 64% of its funding base was made up of deposits. By the end of the second quarter of this year, that number had risen to 85%. But with a total return of 1.16% on its total funding base, Ally’s funding is still much less sticky and more expensive than many other big banks, which will inevitably lead to higher deposit costs in the future. close, given the aggressive Fed hikes.

Why Buffett is making this bet

Considering that Berkshire’s stake is only 0.1% of his large portfolio, I think Buffett understands that this bank is risky. But it’s probably a bet that the Oracle of Omaha and Berkshire view as favorable in terms of a risk-reward proposition, given Ally’s cheap valuation. The stock trades at five times forward earnings and around 90% of its tangible book value, or net worth.

Ally’s management team has recognized the challenges, modeled a significant decline in used car prices, and still believes it can generate a sustainable return of 16% to 18% or more on medium-to-medium tangible equity. term. If they succeed in tougher economic conditions, the stock will certainly trade higher.

Additionally, Ally has a strong track record of buying back a lot of stocks and, at its current price, has an annual dividend yield of 3.4%, two other things that Buffett and Berkshire love.

Ally is an advertising partner of The Ascent, a Motley Fool company. Bram Berkowitz has no position in any of 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.

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