So Far So Good for One of Warren Buffett's New Stocks

Berkshire Hathaway (BRK.A 0.14%) (BRK.B 0.19%), the large conglomerate run by legendary investor Warren Buffett, opened a new stake in the large digital consumer bank Ally Financial (ALLY 4.18%) in the first quarter of 2022. Berkshire then followed that up with an even larger purchase of Ally in the second quarter of 2022.

Ally has been a hotly debated stock, with many concerned about how its retail auto loan portfolio might perform as used car prices start to normalize after exploding due to the chip shortage caused by the pandemic.

While the stock got crushed in 2022, Ally’s thesis and management’s expectations for the company have largely played out as expected so far, which bodes well for Berkshire’s new stock.

Image source: Getty Images.

All eyes on credit

The market is keenly focused on Ally Financial’s retail auto portfolio after years of fast growth and benign credit quality on the back of higher vehicle prices, especially for used vehicles. Ally’s retail auto loans at the end of the fourth quarter of 2022 almost reached $84 billion, which is up by more than $11 billion since the end of 2019.

Quarterly originations peaked at more than $13 billion in the second quarter of 2022, which is up significantly from the $9.7 billion of originations Ally peaked at in the second quarter of 2019.

While Ally’s charge-offs, debt unlikely to be collected and a good indicator of actual loan losses, jumped significantly in the fourth quarter, it seems to be in line with management’s expectations. The companywide net charge-off rate hit 1.16% in Q4, while the retail auto net charge-off rate hit 1.66%, which is up from 1.05% in the third quarter of 2022.

But Ally is reserving for loan losses well in excess of where it expects charge-offs to peak. Its assumptions include a 13% decline this year in used vehicle prices. The company also has significant excess capital above its regulatory requirement that it can use for unexpected loan losses. Additionally, in the fourth quarter, management showed how they expect charge-offs to trend in the retail auto portfolio throughout 2023, demonstrating that they seem to have the situation under control.

Improved guidance

Ally also provided earnings guidance for the full year and for 2024, which was better than what the market had been expecting. The company expects adjusted earnings per share of $4 this year, which would be down from $6 in 2022, and then earnings to rebound back to $6 per share in 2024.

That’s slightly better than what Wall Street had been modeling this year and significantly better than the $4.90 earnings consensus for 2024. This also suggests a mid-teens percentage return on tangible common equity (ROTCE), which is much better than the returns the company generated prior to the pandemic.

The assumptions driving these estimates are negative economic growth in 2023, unemployment peaking at 5%, and the Federal Reserve’s benchmark lending rate peaking at 5%. While there is a lot of uncertainty in the air right now, I believe these assumptions are pretty much in line with what most of the market is thinking right now, not that things couldn’t change.

Ally believes it will continue to be able to originate auto loans with high yields thanks to the rising interest rate environment. Management on the earnings call said they are originating auto loans in the 10% range in the current quarter, which is incredibly high and should appropriately price in the risk in the current environment. Management also said they expect the bank’s margin to trough at 3.5% this year and then gradually rise back to 4% over time.

Buffett is on the mark so far

While Buffett and Berkshire may not have expected Ally’s stock to fall so significantly in 2022, I believe their thesis is likely playing out in which Ally manages credit effectively and then is able to generate higher returns going forward than pre-pandemic.

Buffett is also known for being a value investor, and even after a recent run-up in Ally’s stock, it still has a very attractive valuation. Ally’s stock currently trades at about $32 per share. The bank’s tangible book value per share was $30 at the end of 2022, so the bank is trading just over its net worth.

However, Ally is currently sitting on paper losses from its bond portfolio. But as bond values recover, ideally with the stabilization of interest rates, those losses should be recouped. If they are, Ally’s tangible book value will rise to $44 per share, so the bank could be trading at a much larger discount to its tangible book value than it appears.

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 has positions in and recommends Berkshire Hathaway. The Motley Fool recommends the following options: long January 2023 $200 calls on Berkshire Hathaway, short January 2023 $200 puts on Berkshire Hathaway, and short January 2023 $265 calls on Berkshire Hathaway. The Motley Fool has a disclosure policy.