Holy smokes, Batman. Meredith Whitney is at it again! You'll recall, she's the banking analyst who infamously predicted in an interview with "60 Minutes" that "hundreds of billions" of dollars in municipal bond losses would occur in 2011. She was way off the mark, though. Only about $3 billion in losses was actually reported. So we gave her the honor of making The Worst Prediction of 2011.
Well, fast forward to today and she's dusting off her crystal ball again - on Bloomberg Television, no less. This time around, she's predicting that "Bank of America (NYSE:BAC) is the stock to own this year." Is this just another attention-grabbing media stunt? Or a bona fide prediction that we should consider acting on? My answer might surprise you.
The Only Smart Way to Invest
First things first, I need to confess that my crystal ball doesn't always work, either. So I can't be too tough on Whitney. Take, for instance, my call back in August 2011 that Bank of America was a screaming "Buy" on the heels of Warren Buffett's investment. By the end of the year, shares dropped almost another 30% in value.
Of course, I did double down on my erroneous call, saying that Bank of America would "rally mightily in 2012." And it did. In fact, it ended up being the top-performing stock in the Dow Jones Industrial Average last year, rising 109.5%.
I bring this up not to brag. Instead, I want to put Whitney's call into perspective. It's more about momentum than boldness. And based on the results of our own personal "stress test" on Bank of America, I'll concur with her that the momentum will most likely continue. But I don’t agree with her on how to profit from it. (More details on that in a moment.)
First, let's cover the six reasons why I expect the bullish trend to continue for Bank of America in 2013:
Reason No. 1: First In, First Out
The banks got us into the financial crisis. So it stands to reason that they need to lead us out, too. That recovery is undeniably under way. But given the severity of the downturn, we still have a long way to go.
Just look at Bank of America's results. In the six years leading up to the recession, it averaged about $14.5 billion in net income. Over the last 12 months, though, the company's net income checked in at roughly $5.5 billion. By that metric alone, profits need to more than double before we're back to pre-recession averages. And since share prices ultimately follow earnings, it's not a stretch to expect that shares could double again, too.
Reason No. 2: Top of the Tier
Bank of America has engaged in an aggressive effort to shore up its finances by restructuring, cutting costs and selling off assets. In fact, the company remains on track to shed $8 billion in annual costs by mid-2015.
The end result? Its Tier 1 Capital Ratio, which is the industry standard measurement of financial stability, currently ranks at the top of the list for the nation's largest banks, at 9.25%. So if we're betting on a banking recovery, it makes sense to bet on the bank that's the strongest financially, right?
Reason No 3: A Building Recovery
We can all agree that the residential housing market is recovering. It's still in the early stages, though. So as consumers refinance and take out new mortgages, banks stand to book even more profits. In other words, the housing market is finally switching from being a hindrance to a help in terms of banks' profitability.
Reason No. 4: Still on Sale
Even after the impressive run-up last year, Bank of America's stock represents a good bargain. The forward price-to-earnings (P/E) ratio of 9.4 is 32.4% less than the forward P/E ratio for the average stock in the S&P 500 Index.
As Stephen Weiss of Short Hills Capital notes, the stock is "still" cheap on a price-to-book (P/B) basis, too. Shares currently trade at about a 40% discount to the industry P/B ratio.
Reason No. 5: Institutional Support
When it comes to investing, I typically advise against betting with the crowd. The one exception? When the crowd is heavy-hitting institutional investors. The size of their bets provides much-needed support to share prices. If you have any doubt, just ask Apple (NASDAQ:AAPL). New data from Reuters suggests that the massive drop in Apple's share price in the fourth quarter was precipitated by big hedge funds selling out of their positions.
In Bank of America's case, however, institutional investors are mostly doing the opposite. For instance, Europe's largest hedge fund, Lansdowne, purchased 26.5 million shares in the fourth quarter, according to regulatory filings. Both Adage Capital Management LP and Arrowstreet Capital LP purchased 14.7 million more shares. The list goes on.
It's also important to note that these purchases came after the stock rose 55% in the first three quarters of 2012. It stands to reason that hedge funds wouldn't be making such sizable bets in recent months unless they expected much more upside ahead. Any additional purchases promise to provide an additional boost to share prices, too.
Reason No. 6: Dividends, Please
Retail investors' love affair with dividend-paying stocks continues to heat up. And if Bank of America increases its dividend this year, which is a strong possibility, it could lead to a massive influx of dividend investors. The trick, of course, is being positioned ahead of any such moves.
Buying Shares Isn't Enough
To be fair, risks remain for Bank of America's business - such as unknown settlement costs for past mortgage practices, continued deleveraging by consumers, and historically low interest rates, which squeeze profit margins. No doubt, such factors prompted some institutional investors to take their profits and run. In the last quarter, hedge fund Perry Corp. sold out of its entire 7.5 million-share position.
Meanwhile, other investors, like Boston-based Geode Capital Management LLC, pared back their holdings by about 10%. On the whole, though, the investment case for Bank of America remains much more bullish than bearish.
Whitney expects the stock to top $15 per share in the next six to nine months. I think that's a conservative estimate. But let's go with it anyway. Doing so implies that the stock carries about a 25% upside to current prices.
I'm sorry. But that's not enough profit potential to earn a "must own" distinction from yours truly.
Bottom line: Forget simply buying Bank of America's stock, as Whitney suggests. If you want to profit from this momentum trade, I recommend buying just out-of-the-money LEAPS options, instead. Doing so involves tying up about 90% less capital. So it limits our downside and frees up capital to invest in other compelling opportunities. At the same time, it also increases our profit potential by putting the power of leverage to work in our favor.
Less risk and more potential profits? Who doesn't want that?