With the common stock price of Bank of America (BAC) more than doubling in 2012 to just over $11, it is worth revisiting the case for a value investor. This case was made straightforwardly by Bruce Berkowitz in late 2011 after 13F filings showed his Fairholme Fund increased its holding of BAC by 5% to 105 million shares.
Framing the Valuation
At its most basic, the value case is that if you invest in a company with a 10% return on owners' equity (being the ratio of owners' earnings to owner's equity) at half of the value of this equity (i.e. half of so-called "book" value), then, arithmetically, the implied annual return on your investment is 20%.
In practice, the usual analysis is to unpack the return-on-equity into a return-on-assets and an assets-to-equity ratio. This allows the impacts of profitability and leverage to be looked at separately. For the first three quarters of 2012, Bank of America reported a return on owners' equity of 1.48% arising from a leverage (i.e. assets-to-equity) ratio of 7.04x on a return-on-assets of 0.21%; the arithmetic is simply that 1.48% = 7.04 x 0.21%.
In summary, a value-based analysis can look at profitability as measured by return-on-assets, leverage as measured by the assets-to-equity ratio, and the price of the stock relative to the owners' equity. These elements are discussed in turn below along with a comment on the possible impact on owners' equity of the bank's exposure to litigation arising from the mortgage crisis.
A first component of the value case for BAC is that the return on assets will increase from current levels. In the 2011 Annual Report management commented that asset returns are presently depressed, citing, among other things, the ongoing effects of the mortgage crisis (and, in particular, the bank's need to set aside capital to cover possible litigation losses) and current low interest rates (which reduce the earnings from the bank's deposit-taking activities).
A complete analysis would look towards independent quantification of management's claims but we can get some sense of a possible more "normal" return-on-assets from history. For example, over the five years from 2002 to 2006, BAC reported an average return-on-assets of 1.4%. Of course, this included the excesses before the financial crisis and needs to be reduced to reflect less aggressive business practices and a greater regulatory burden. In his example, Bruce Berkowitz used a "normal" return of 1% while Jamie Dimon, the CEO of JP Morgan Chase (JPM), has suggested normal returns for the bank he leads of 1.3%. (Specifically, in his letter to shareholders in the 2011 Annual Report for JPM, Mr. Dimon wrote that "earnings should have been $23-24 billion" corresponding to a return-on-average-assets of 1.3%). For the sake of this analysis, we take a mid-point value of 1.1%.
On average, over the five years from 2002 to 2006, BAC operated with a leverage (i.e., assets-to-equity) ratio of 12.6x so that the above 1.4% return-on-assets generated a 17.6% return-on-equity. Since then, the leverage ratio has fallen largely on the insistence of regulators (acting, in particular, on global regulatory standards agreed in 2011 in response to the recent financial crisis and referred to as the Third Basel Accord or BASEL III). For instance, in the first three quarters of 2012, BAC operated with a leverage ratio of just over 8x.
A second key component of the value case for BAC is that the leverage ratio will increase from these levels as regulators become more comfortable with the bank's risk management and possible litigation exposure. This analysis assumes a "normal" leverage ratio of 10x.
Combined with the above profitability assumption of a 1.1% return-on-assets, the assumed leverage ratio of 10x generates a "normal" return-on-equity of 11% (well above the average result of less than 2% for the first three quarters of 2012).
Owners' Equity ("Book" Value)
At the end of the third quarter, BAC reported book value per share of $20.4. With the stock price currently at $11, this suggests the opportunity to buy in at a valuation of roughly 50% of owners' equity. Given the assumed return-on-equity of 11% from above, the return on investment is over 20% (since only about 50 cents is actually invested for every $1 of book value). This is a satisfactory return and is likely the appeal of BAC to some value-based investors.
Of course, the investment return may not hold up if the book value is unreliable. An immediate concern is that the book value may overstate the realizable value of assets in liquidation or the fair value assuming the business continues as a going concern. Investors have been made sensitive to the potential for overstatement by banks given the large write-downs in real-estate related assets experienced as the financial crisis unfolded through 2008.
There is a particular concern around so-called "intangible" assets (which can arise, for example, when one company acquires another) so that some analysts prefer to work with "tangible" book value. In the case of BAC, the "tangible" book value was $13.5/share at the end of the third quarter and so only two-thirds of reported book value. This could be a problem for the analysis if the intangible assets turn out to generate lower returns than the tangible assets. That said, BAC has already taken "impairment" charges to reduce the book value of intangible assets where they may have exceeded fair value.
In 2011, BAC set aside earnings of $15.6 billion to cover the risk of losses associated with allegations of improperly selling mortgages in the years leading up to the financial crisis of 2008. Specifically, companies that purchased or insured mortgages (or related securities) made by BAC have alleged that the bank provided misleading information and so is responsible for some portion of the associated losses. Some cases have been settled and others may proceed to litigation.
To get an idea of the scale of the issue, it is worth noting that but for these mortgage-related "provisions," BAC would have generated a return-on-assets in 2011 of around 0.5% versus the reported 0.06%. A risk to our value-based analysis is that the provisions, large as they were and even though supplemented with a further $1 billion in the first three quarters of 2012, may not be sufficient; indeed, management has suggested the bank may need to set aside another $6 billion.
In practice, an additional $6 billion provision would not meaningfully change the valuation analysis since, after adjusting for taxes, the amount represents less than 40 cents/share of book value (or 2% of the reported $20.4/share). In fact, there is enough margin of safety in the analysis to absorb provisions considerably in excess of management's range of possible losses, provided the bank could reasonably meet regulatory capital standards, although these would likely cause a meaningful and immediate decline in BAC's stock price.
A value-based analysis suggests that, even after the doubling in price in 2012, the common stock of BAC may generate a go-forward annual return on investment of 20%. This could be higher if the bank generates a return-on-assets consistently above 1.1% or increases leverage so that the assets-to-equity ratio exceeds 10x.
The investment return could be lower if it turns out that the bank's reported book value/share of $20.4 is unreliable. Other things being equal, each $1 reduction in book value/share (equivalent to approximately $16 billion of pre-tax losses) reduces the annual return generated in the analysis by approximately 1%.