Is It Time To Follow Buffett Into This ‘Hated’ Stock?

You’ve no doubt heard many times that one of the best ways to make money in the stock market is to buy stocks when they’re “hated.” In fact, Warren Buffett has followed this path to profits countless times and used it to amass his vast fortune.

I don’t think I could find many stocks that have been more “hated” over the past few years than Bank of America (NYSE: BAC). From its role in the financial crisis and housing bubble to ongoing litigation issues associated with those dark chapters for the economy, it seems like the company can’t catch a break.

But, of course, just because a stock is hated doesn’t mean you should buy it. To determine this, we have to look much deeper.#-ad_banner-#

But before we do that, the first and most obvious thing to consider is that none other than Buffett himself has issued a vote of confidence in Bank of America, as evidenced by his $5 billion stake in preferred shares, which come with a steady 6% yield.

We don’t have the luxury of getting a sweetheart deal like this, but we can look to some of his recent comments about the company to get a clue into his thinking on the current status of the company — and Buffett has said Bank of America’s mortgage issues are being addressed.

The stock’s current price is considerably below its book value of about $20, but that discount accounts for the lack of clarity about the bank’s future. For one, the company is still dealing with the fallout from subprime lending issues, largely tied to its acquisition of Countrywide Financial, and the housing market downturn.

Most recently, the federal government sued Bank of America, accusing it of misleading investors in about $850 million of mortgage-backed securities. According to the suit, the bank led investors to believe that the securities were backed by prime jumbo mortgage loans and did not adequately disclose the risks involved. Earlier this year, Bank of America settled with mortgage financier Fannie Mae (OTC: FNMA) over loans that Fannie claimed were substandard and wanted Bank of America to buy back.

Bank of America isn’t alone in its mortgage issues: The bank committed to cash payments of $1.1 billion and other assistance of $1.8 billion in a settlement with other banks and the government to help mortgage borrowers with loan modifications.

The most recent government lawsuit comes just when Bank of America is cutting down significantly on its litigation expenses, which were $471 million in the second quarter, down from $2.2 billion in the first quarter and from $963 million in last year’s second quarter.

Still, Bank of America reported good results for the second quarter, with net income up 63% from a year ago, to $4 billion. Earnings per share (EPS) for the period were 32 cents a share, up 68% from last year. However, revenue was up a mere 3%, meaning that profit increase was achieved through cost-cutting and a reduction in loan loss reserves as the economy improved.

Bank of America’s 2009 acquisition of Merrill Lynch is bearing fruit, with its global wealth and investment management business division reporting second-quarter revenue of $4.5 billion, up about 10% from a year ago. The division’s assets under management also increased, and asset management fees jumped 10%. The bank also reports that it is able to meet standards showing it has enough capital to weather losses.

Annualizing its EPS for the second quarter, the company’s price-to-earnings ratio is a reasonable 11.35, and its price-to-book ratio is an attractive 0.7. Although BAC’s current dividend yield is only about 0.3%, management could buy back as much as $4 billion in stock.

Risks to Consider: The major risk facing Bank of America stems from the liabilities related to its mortgage lending and securitization activities. While the improvement in the housing market means that the worst of the downturn is likely behind us, other claims could surface against Bank of America, particularly in connection with the subprime activities of Countrywide Financial, which Bank of America acquired in 2008.

Action to Take –> BAC is unlikely to test the lows it saw in early 2009, when it sank all the way to $2.53, down from more than $50 a share in 2007. And BAC does present considerable upside, considering it may regain its luster as the economy improves. Even then, what worked for Warren Buffett might not work for you, given the considerable headline risk associated with BAC. Those enticed to buy by Bank of America’s value proposition may want to wait a bit to see how things play out.

P.S. — The worst of the mortgage crisis might be behind Bank of America, but the entire banking industry could be facing a huge new threat — from Apple. To find out how the tech giant’s recent $256 million move could be bad news for banks, click here.