It is amazing to think that just two years ago, media pundits were proclaiming the demise and possible insolvency of Bank of America (NYSE:BAC) despite obvious improvements in capital metrics and credit trends. It was that uncertainty in the midst of the European Crisis that set the stage for Warren Buffett and Berkshire Hathaway's (NYSE:BRK.A) (BRK.B) $5 billion investment in preferred stock attached with warrants, which has already been highly lucrative for Berkshire. When business fundamentals differ materially with stock prices, as they did in 2011, there is an opportunity for long-term value investors and that is still very much the case with Bank of America, where market participants aren't properly valuing the business in spite of the obviously improving fundamentals and discounted valuation. I believe Bank of America has the potential to double over the next 3-5 years and I believe that the margin of safety created by the discounted valuation makes for one of the most attractive risk-adjusted reward opportunities in the market.
When you think about the qualities that make for a good banking business and disassociate yourself from recent history, Bank of America stands out as an enormously powerful competitor. The bank is blessed with one of the lowest cost and largest deposit bases in the industry, which will allow enormous earnings leverage when net interest margins do finally expand materially. The Merrill Lynch acquisition gave the bank access to an extremely productive group of financial advisors that boast pretax margins in the mid-20% range, which are the envy of much of the industry. Bank of America's capital ratios reflect incredible security and durability to handle the most traumatic of economic environments. Bank of America is a fixture in American society with one of the largest branch and ATM footprints across the nation, and a leading position in the rapidly growing mobile banking market. Despite these advantages, the bank still trades at a significant discount to book value and a slight premium to tangible book value.
This is where emotion and market participants' short-term bias to the recent past comes into play. Bank of America's acquisition of Countrywide Financial made it the whipping boy of regulators and class-action attorneys, despite the fact that the most grievous offenses occurred long before the acquisition. When Buffett bought into the company's preferred stock, I believe that he saw a leader in Brian Moynihan who had the right plan, attitude and ability to execute after taking over for imperially ignorant Ken Lewis. Moynihan realized that capital was the number one issue so he monetized non-core assets such as the stake in China Construction Bank. He eschewed calls for a dividend or stock buyback to focus on meeting abstract yet demanding capital and regulatory requirements, while focusing on a massive cost-cutting program that will right-size the company's operations given the current economic environment. Returns on assets and equity are still far lower than they will be once the company isn't burdened with the legacy asset servicing business, but each quarter the company's performance has gotten better. Moynihan has done exactly what he said he would, despite an extremely difficult operating and regulatory environment, which augurs exceptionally well for the future when the company faces fewer headwinds and can really focus on profitability and shareholder returns.
On October 16th, Bank of America reported reasonably strong 3rd quarter financial results given the very difficult macroeconomic backdrop. Net income rose to $2.5 billion in the quarter from $340MM at the same time last year. There were a few one-time issues that impacted the results including a pretax gain of $.8 billion on the sale of the remaining China Construction Bank shares, partially offset by $0.4 billion in negative valuation adjustments, resulting in a $0.02 benefit to earnings per share. In addition there was a $1.1 billion charge, or $0.01 EPS, related to a reduction in the U.K. tax rate. Earnings per diluted share increased to $0.20 from $0.00 in the year ago period. Year-to-date through three quarters, the banks has posted net income of $8.0 billion, which is up from $3.5 billion at the same time last year. The net interest margin in the 3rd quarter was 2.44%, which was up from 2.32% in the 3rd quarter of 2012. Earnings have been bolstered by a combination of strong loan growth, expense reductions and improving credit quality. Commercial loan balances of $395 billion are up 19% from the same time last year and the company was still able to fund $24 billion in residential home loans and home equity loans in the quarter, despite the increase in interest rates. Noninterest expense was $16.4 billion; down from $17.5 billion in the year ago quarter, driven largely by lower litigation expenses, reduced expenses in Legacy Assets and Servicing (LAS) and lower personnel expenses. Credit quality improved dramatically with net charge-offs down 59% from the 3rd quarter of 2012. The company's low-cost deposit franchise continues to be a source of strength as total consolidated deposit balances rose 4% from the 3rd quarter of 2012 to a record $1.1 trillion.
Bank of America truly has one of the strongest balance sheets in the company's history. The Basel 1 Tier 1 Common Capital of $143 billion is equivalent to a ratio of 11.08%, up from 10.83% in the 2nd quarter. The estimated Basel 3 Tier 1 Common Capital Ratio at the end of the quarter was 9.94%, up from 9.6% in the 2nd quarter. The estimated Bank Holding Company Supplementary Ratio increased to above the proposed 5% minimum. Since the same time last year, Bank of America has reduced its long-term debt by $31 billion, driven largely by maturities and liability management actions, which have served to improve net interest margins in this low interest rate environment. Parent company liquidity is exceptionally strong with a time-to-required funding of 35 months. These metrics being so strong have set the stage for a high likelihood of increased stock buybacks and dividends when the next CCAR process occurs in 2014.
Based on 10.683282 billion shares outstanding and a recent price of $14.50, Bank of America has a market capitalization of approximately $155 billion, versus shareholders' equity of $232.282 billion. The stock trades at about a 29% discount to book value and I'd expect to see book value grow at an accelerated rate, bolstered by retained earnings and stock buybacks below book value. While a return on equity of 10% has been elusive for the banks thus far, I have absolutely no doubt that Bank of America will be able to achieve that within the next 3 years, barring a significant recession. I peg normalized earnings at $2.00-$2.50 per share and once again, stock buybacks could be highly accretive given the excess capital that I forecast the bank generating over the next several years. Analysts and market participants have had a variety of reasons to not recommend or buy Bank of America but the stock has performed very well since late 2011, and I believe that the odds are very high that the stock will double within 3-5 years, while also paying an attractive dividend.
Disclosure: I am long BAC, BRK.B. 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.