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

In the first quarter of the year, Warren Buffett and his company Berkshire Hathaway (BRKA 0.97%, (BRK.B 0.95%, Bought about 9 million shares – about 2.9% stake – in the big digital bank Allied Financial (Associate 2.68%,, which specializes in auto lending. With inventories still being challenged and used-car prices rising, Ally has flourished, generating strong financial results since the pandemic began.

But given its cheap valuation, the market clearly isn’t buying the ally’s earnings stability. Buffett and the market clearly differ here. Who would be right?

A strong auto market has delivered strong results

When the pandemic initially hit 2020 and wide swaths of the economy were shut down for months at a time, the streets really cleared up as people stayed home. Due to reduced travel demand, many automakers slowed down their production. But as the economy returned to normal and people took to the streets again, the industry ran into supply chain issues – particularly around semiconductor chips – that Has sustained And kept the goods low. This has led to an increase in the prices of cars across the board, especially among older vehicles, which have increased by almost 60% as compared to 2019.

A photo of Warren Buffett.

Image source: Motley Fool.

This bodes well for Dynamic Alley’s auto business. At the end of the second quarter, Ally had retail auto loans of more than $82 billion, up $9.5 billion since 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 Associates deliver a 23.2% core return on tangible common equity in the second quarter.

And the strength has clearly continued in the third quarter, according to Ally’s CFO Jane LaClaire, who said pricing continues to rise. Original return on retail auto loans in the second quarter came in at 7.82%, up 75 basis points from the first quarter. LaClair said the bank is now introducing retail auto loans at 8% while maintaining its underwriting norm.

LaClaire said the company still believes the 4 million to 5 million customers who didn’t participate in the auto market due to inventory shortages are good. He added that the application flow remains solid and the company is not seeing much price sensitivity, especially among more affluent customers.

We see really strong application flows among high earners, which we defined as more than $50,000. And we average over $100,000 in terms of revenue for our clients. So in that segment, with the supply crunch and our model, we don’t really see it slowing down.

Emerging Challenges for Allies

Despite good results and strong near-term demand, investors and analysts fear a time when conditions return to normal to pre-pandemic levels could lead to credit problems, especially given that some loans How big are the reasons for the high auto prices.

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

Another issue analysts worry about is funding costs, due to a sharp increase in Federal Reserve interest rates in recent months. Over the years, Ally has done a really great job of improving its core deposit base. In 2018, just 64% of its funding base was made up of deposits. That number had risen to 85% at the end of the second quarter of this year. But with an overall yield 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 inevitably see the Fed’s aggressive hikes in higher deposits in the near future. will incur costs.

Why is Buffett making this bet?

Given Berkshire’s holdings account for only 0.1% of its large portfolio, I think Buffett understands there are risks involved. Bank, But given the ally’s cheap valuation, it’s likely to be favorable to a risk-reward proposition from the Oracle of Omaha and Berkshire. The stock trades at five times forward earnings and about 90% of its tangible book value, or net worth.

Ally’s management team acknowledges the challenges, has modeled a significant decline in used car prices, and still thinks they can deliver sustainable 16% to 18% or more returns on tangible common equity over the medium term. can generate. If they make it through more difficult economic conditions, the stock will most certainly trade higher.

In addition, Ally has a strong track record of repurchasing a lot of stock and, at its current share price, an annual dividend yield of 3.4%, two other things Buffett and Berkshire love.

Ellie is the advertising partner of The Ascent, The Motley Fool Company. bram berkowitz Have no position in any of the stocks mentioned. The Motley Fool has positions and recommends Berkshire Hathaway (B Share). The Motley Fool recommends the following options: long January 2023 $200 call on Berkshire Hathaway (B Shares), January 2023 $200 short call on Berkshire Hathaway (B Shares), and January 2023 $265 short on Berkshire Hathaway (B Shares). Call. The Motley Fool has one Disclosure Policy,

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