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This Underappreciated Warren Buffett Stock Is a Screaming Buy, but Only if This Happens

Motley Fool - Mon Feb 26, 5:00AM CST

While well-known consumer brands like Apple and Coca-Cola get a lot of attention among Berkshire Hathaway's top holdings, there are much smaller positions that might present some attractive opportunities.

Consider Ally Financial(NYSE: ALLY). Warren Buffett's conglomerate owns 9.6% of the digital bank's shares outstanding. But the stake represents just 0.3% of Berkshire's entire portfolio, making it a tiny position.

Ally shares have risen just 35% in the last five years, and they currently trade below book value. In the banking industry, that's an attractive valuation because it indicates the business sells at a discount to the entire value of the equity it owns.

Consequently, this bank stock is a screaming buy. But that's only if you believe this one thing will happen.

Unfavorable trends

Ally had a terrific year in 2021. Its revenue of $8.2 billion and net income of $3 billion were up 23% and 177%, respectively, from the previous year. It's not a surprise that a strong economic backdrop helped drive these gains.

But thanks to the Federal Reserve's tighter monetary starting in early 2022, Ally's financials have taken a hit. While revenue in 2023 was roughly in line with the 2021 total, net income declined 70% from two years before. Lower demand for loans, coupled with higher provisions for credit losses, hurt the business.

The challenges probably explain why the stock is currently 35% below its peak price from June 2021, although it has soared almost 35% in the past three months.

Waiting for improvements

If you believe the macroeconomic environment will become more favorable in the near term, then this perspective makes Ally shares a no-brainer buy right now. What exactly do these positive developments look like?

Lower interest rates would be a start. The central bank has hinted at multiple rate cuts this year, which would allow Ally to offer lower rates on its $142 billion of retail deposits. This could help to expand net interest income, while at the same time bringing down net charge-off rates, which were much higher in 2023 than two years ago. Lower rates could also boost demand for loans.

Because 56% of Ally's loans and leases in Q4 were represented by retail auto loans, a stronger industry backdrop would boost the company as well. According to the CarGurus Index, U.S. used car prices have been falling since the start of 2022. This hurts Ally because lower prices let buyers finance purchases with smaller loans. And on the back end, should the bank repossess a car for nonpayment, a softer market means lower resale values.

Chief Financial Officer Russ Hutchinson mentioned on the Q4 2023 earnings call that 65% of Ally's auto loan originations last quarter were for used vehicles. Having a strong market to operate in can drastically alter Ally's situation.

The leadership team remains optimistic. It expects net interest margin (NIM) and earnings per share (EPS) to reach 4% and $6, respectively, over the medium term once industry and economic conditions stabilize. Both of these figures would be monumental improvements from the NIM of 3.35% and EPS of $2.98 reported in 2023.

Making difficult predictions

On the one hand, it's hard to ignore Ally's beaten-down stock price and low valuation. Given that the economy spends more time growing than in a downturn, I can understand why some investors would want to take a chance and buy these shares.

However, I'm not as bullish. I always worry when a business depends so heavily on a lot of external factors to go right for it to produce solid financial results. This mentality causes me to avoid this Buffett banking stock.

Should you invest $1,000 in Ally Financial right now?

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Ally is an advertising partner of The Ascent, a Motley Fool company. Neil Patel and his clients have no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Apple and Berkshire Hathaway. The Motley Fool has a disclosure policy.

Paid Post: Content produced by Motley Fool. The Globe and Mail was not involved, and material was not reviewed prior to publication.

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