Warren Buffett is betting on a title that the market doesn’t like

In the first quarter of the year, Warren Buffett and his company Berkshire Hathaway (BRK.A 0.23%) (BRK.B -0.04%) bought nearly 9 million shares – a stake of about 2.9% – in the large digital bank Financial ally (ALLY -0.68%), specializing in auto loan. With inventory still struggling and used car prices soaring, Ally has grown, generating strong financial results since the start of the pandemic.

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

A strong automotive market has led to excellent results

When the pandemic first hit in 2020 and large swaths of the economy closed for months, the streets were truly cleared while people stayed home. Due to this lack of demand for travel, many car manufacturers have slowed down their production. But as the economy normalized and people started walking the streets again, the industry ran into problems in the supply chain, particularly with semiconductor chips, which persisted and kept inventories low. This has led to car prices across the board, particularly among used vehicles, which have risen by around 60% compared to 2019.

A photo of Warren Buffett.

Image source: Motley Fool.

This dynamic was positive for Ally’s automotive business. At the end of the second quarter, Ally had over $ 82 billion in retail auto loans, up $ 9.5 billion from the second quarter of 2019 and $ 6.4 billion year-over-year. Meanwhile, the average portfolio return on these retail loans is 6.85%, up 10 basis points (0.10%) from the first quarter of the year. This helped Ally achieve a 23.2% principal return on tangible common equity in the second quarter.

And the strength apparently continued into the third quarter, according to Ally’s CFO Jenn LaClair, who said prices continued to rise. Retail auto loan origination yields in the second quarter were 7.82%, up 75 basis points from the first quarter. LaClair said the bank is now making retail auto loans at 8% while maintaining its underwriting criteria.

LaClair said the company still believes there are 4 million to 5 million customers who are not participating in the automotive market due to inventory shortages. He added that the application flow has remained solid and the company doesn’t see much price sensitivity, particularly among wealthier customers.

We see a really strong stream of questions in the highest income earners, which we have defined as some sort of over $ 50,000. And our average in terms of the income of our clients we come with is over $ 100,000. So in that segment, with supply constraints and our model, we don’t really see this slowdown.

Challenges looming for Ally

Despite strong results and strong short-term demand, investors and analysts fear the moment when conditions will normalize to pre-pandemic levels, which could lead to credit problems, especially considering the amount of some loans owed. to the increase in car prices.

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

Due to the Federal Reserve’s sharp rise in interest rates in recent months, another issue analysts are concerned about is funding costs. Over the years, Ally has actually done a great job of improving her basic deposit 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 jumped to 85%. But with a total return of 1.16% on its total funding base, Ally’s funding is still far less sticky and more expensive than many other large banks, which will inevitably lead to higher deposit costs in the near future. given the Fed’s aggressive hikes.

Because Buffett is making this bet

Considering that Berkshire’s holding amounts to only 0.1% of its large portfolio, I think Buffett understands that this bank carries risks. But this is likely a bet that Oracle of Omaha and Berkshire consider favorable in terms of a risk-return proposition, considering Ally’s economic valuation. The stock trades at five times forward earnings and approximately 90% of its tangible book value, or equity.

Ally’s management team recognized the challenges, modeled a significant drop in used car prices and continues to think they can generate a sustainable return of 16% to 18% or more on tangible common assets over the medium term. If they achieve this through tougher economic conditions, the stock will certainly trade higher.

Additionally, Ally has a solid track record of repurchasing many shares and, at her current share price, has an annual dividend yield of 3.4%, two other things 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 titles mentioned. The Motley Fool has positions and recommends Berkshire Hathaway (B shares). The Motley Fool recommends the following options: long January 2023 $ 200 call on Berkshire Hathaway (B shares), short January 2023 $ 200 put on Berkshire Hathaway (B shares) and short January 2023 $ 265 call on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.

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