Bank Of America's Mean Reversion Illustrated

| About: Bank of (BAC)

Bank of America (NYSE:BAC) has been a continual underperformer amongst large money center banks since the financial crisis. As a result, the bank trades at 0.6 times book value. Recently, the most popular investment thesis for the company is a 'mean reversion' trade. This article looks at how much mean reversion potential there is for the bank going forward and the steps the bank is taking to achieve this.

Their underperformance has been largely attributed to mismanagement and the acquisition of Countrywide during the crisis. The bank is working hard to put these troubles behind them with new cost-cutting steps being taken by Brian Moynihan. Additional information on these cost-cutting steps should be provided in their next earnings report, which could prove to be a positive catalyst for the stock. Also, their legal troubles stemming from Countrywide and other mortgage deals are slowly being resolved.

All of these efforts are being recognized by the Fed as demonstrated by the CCAR results. Part of the bank's success in the test was certainly due to the company's limited exposure to trading revenues, which had a significant negative impact on the results from JPMorgan (NYSE:JPM) and Goldman Sachs (NYSE:GS). The bank is in the process of buying back up to $5 billion in shares and $5 billion in debt.

These two buybacks will help the company's profits going forward - but only at the margin. The biggest concern for long-term investors is how the company's core businesses are performing. For banks, this can be simplified as the bank's Net Interest Margin (NIM) and their charge-off ratio.

The chart below compares Bank of America's NIM (from quarterly reports) since Q1 2009 with the industry average for large banks (as reported by FRED). Bank of America's NIM has been consistently below the industry average since the financial crisis. The spread between the two illustrates the potential for the bank to be more profitable in the coming years. The continually low NIM illustrates a bearish talking point on the stock.

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Another widely watched measure which correlates to bank profitability is the ratio of charge-offs on loans. Given the relatively small profit made on each loan, any changes in the amount of loans lost can have a big impact on earnings. The chart below compares Bank of America's charge-off percentage since Q1 2009 with the industry average (as reported by FRED).

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Again, Bank of America's charge-off ratio is worse than the industry average though BAC has significantly improved this metric over the past few years and is close to the industry average.

As investors who discuss a mean reversion know, these two metrics don't have to improve to something that is better than the industry to have a significant positive impact on earnings. The bank has guided to roughly $10.5 billion in Net Interest Income for the first quarter - which would mean the NIM figure would stay around the current 2.35%, roughly a full percentage point worse than the industry average.

Charge-offs for the bank dropped 6% between Q3 and Q4 of last year. During the Q4 conference call, the bank suggested that the charge-off rate would stabilize from current levels during 2013. This guidance suggests the rate would also be slightly worse than the industry average in 2013.

Shareholders who are investing based on this potential mean reversion should not only look at changes in the bank's NIM and charge-off rates but also how the industry average value changes over the coming quarters. If no significant mean reversion is seen, the bank risks getting stuck with the 'value trap' label.

Disclosure: I am long BAC, JPM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.