Time to buy while it’s hot?

Financial ally (NYSE: ALLY) spooked investors last week. At an investment conference, the executive said that delinquencies and net debits on consumer auto loans have risen in the past two months. That’s not good for the already struggling banking business. If fewer people are paying off their loans, Ally will have less profit. Ally shares fell nearly 20% after the update and now trade around $33.

The largest investor in Ally is Berkshire Hathawayconglomerate run by legendary investor Warren Buffett. The company has maintained its stake in Ally, even though it has reduced most of its exposure to the banking sector over the past year or two. Does Berkshire Hathaway still — at least as of the end of the second quarter — maintain its position in Ally, or does this look like a good buy at a low point?

Let’s take a closer look and find out.

Working with the Tightening Consumer

Rising interest rates over the past few years have squeezed Ally’s profit margins. As a bank, it makes money on the spread between the interest it pays to depositors and the interest it earns on loans and other investments. It specializes in consumer auto loans.

As the Federal Reserve began to raise interest rates rapidly, Ally’s net interest margin (NIM) began to narrow because its existing auto loans were originated when interest rates were lower. When the Fed paused its rate hikes and signaled that it planned to cut rates soon, Ally’s stock began to soar. At one point, it was up 50% earlier this year from a year earlier.

Now, it looks like some of the loans Ally has made over the past few years — especially in 2022 — are doing a little worse than people expected. At an investment conference, the company’s CFO said that auto loan delinquencies and net charge-offs were 10 to 20 basis points higher in July and August than originally forecast. (A basis point is one hundredth of a percentage point.) That means loss rates are up about 0.1% to 0.2%. While that may seem low, Ally had an annual net charge-off rate of 1.81% of its delinquent loans last quarter.

Even a small increase in the number of borrowers defaulting on their loans could mean a big hit to Ally’s earnings power. That’s why the stock fell so much on the news.

In the long run the business model is fine

If Ally has a few bad loans in 2022, that will have an impact on the company’s earnings over the next year or two (auto loans are almost all less than five years old). That’s not good for the company’s earnings potential. But investors should put this in perspective. It’s not like all of Ally’s loans are going bad; they’re just doing a little worse than initially expected. On the conference call, management said the company will still be profitable if recent trends continue.

Investors need to remember that these are just two months of loans. This could be just a short-term dip, not any indication of a long-term trend. Investors should wait for more data before drawing any conclusions. I bet that’s what long-term investors in Berkshire Hathaway are doing.

Long-term, Ally’s business model seems to be in order. Depositors still flock to the digital bank for the high interest rates it pays on deposits — 54,000 were added in the last quarter, bringing the company’s total to 3.2 million. It has $142 billion in retail deposits, almost all of which are insured by the Federal Deposit Insurance Corporation. It can still use those deposits to make auto loans, which is a great business model over the long term. Ally has never had an annual net loss over the past 10 years.

ALLY Net Income (TTM) data by YCharts

Time to buy that dip?

Due to the short-term headwinds from rising interest rates, Ally’s net income fell from more than $2.5 billion in 2021 to $823 million over the past 12 months. That headwind is officially over and could become a tailwind when the Fed starts cutting rates later this year, as expected. Yes, the rising delinquencies could be another headwind, but it’s nothing Ally can’t handle over the long term.

Ally shares currently trade at a price-to-earnings (P/E) ratio of 14.6, which is about half of S&P500 index average. It’s also important to remember that these are low returns. With a market capitalization of just $10 billion, Ally’s P/E could fall to 10 or lower if its annual net income returns to the $1 billion to $2 billion range. Over the longer term, Ally’s earnings could exceed that range if the company attracts more depositors to its consumer bank.

Ignore the short-term noise. Now is a great time to buy Ally’s bottom and hold for years to come. The stock looks very cheap right now.

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Ally is an advertising partner of The Ascent, a Motley Fool company. Brett Schafer has no position in any stocks mentioned. The Motley Fool has a position in and recommends Berkshire Hathaway. The Motley Fool has a disclosure policy.