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After its earnings report last week, it was absolutely clear that Bank of America (NYSE:BAC) is on the right track operationally speaking. However, I believe one factor in particular will play a prominent role for the stock price in 2014. When it can shed its legacy demons tied to mortgage securities, extraordinary gains await it, but until then, it remains hampered on a valuation basis.

Bank of America had all sorts of good news to report for the fourth quarter this past week:

  1. Excellent 15% revenue growth net of interest expense (fully taxable equivalent basis)
  2. Merrill Lynch took market share & noninterest income rose 28%
  3. Net interest margin expansion to 2.56% in Q4 from 2.35% in year ago period
  4. Deposit balances reached a record level
  5. $90 billion in new residential loans extended in 2013
  6. Solid commercial loan growth in Q4
  7. 3.9 million new consumer credit cards were issued in 2013 and usage is higher
  8. Credit quality improved, with net charge-offs down 49% in Q4 comparison
  9. Cost saving efforts cut over a billion dollars in noninterest expense
  10. Return measures show improving economic value creation
  11. And the list goes on…

I thought this paragraph from the company's press release contributed greatly to the stock's 2.3% gain on the day of its report and also depicted the company's current position nicely for the unsophisticated investing public:

"We enter this year with one of the strongest balance sheets in our company's history," said Chief Financial Officer Bruce Thompson. "Capital and liquidity are at record levels, credit losses are at historic lows, our cost savings initiatives are on track and yielding significant savings, and our businesses are seeing good momentum."

It's true that the company is benefiting from economic and real estate recovery like its banking peers Wells Fargo (NYSE:WFC) and JPMorgan Chase (NYSE:JPM). Yes, it is great that loans and assets under management are growing and that investment banking is gaining share. It's wonderful that costs and debt are being reduced and shares repurchased. However, the stock still hinges this year on something else.

One of the company's main focuses has been overcoming legacy issues, those related to the Great Recession and those related to the real estate market collapse and financial crisis. Credit quality is improving steadily:

  1. Net Charge-Off Ratio fell to 0.68% in Q4, from 0.73% in Q3
  2. Provision for credit losses was minimal in Q4
  3. Delinquencies decreased
  4. Allowance for loans and leases were reduced in the quarter as result

This is great news, and I think it played a very important role for the stock last week. Likewise, the company's ability to allow a reserve release of $1.1 billion in the quarter, excluding a regulatory guidance change, played heavily in the press. I noted one expert witness highlighting the fact on business TV, and I must say it affected my level of excitement and probably yours as well. But then I listened to the conference call…

What the experts failed to note was that approximately $2 billion of new reserving in the quarter was required due to increased mortgage securities litigation. Corporate management, on the call, noted some "learning" that occurred recently. That leads me to the settlements that occurred last fall and also what JPMorgan Chase agreed to more recently. Unfortunately, Bank of America cannot overcome the mortgage liability issues of its Countrywide business as easily as it can cut costs, because it is not necessarily within the company's control. If we could finally get passed this issue, then investors could focus even more closely on operational improvement and the great potential for Bank of America. As we look for interest rate increases on economic gains and shifting Fed policy, Bank of America is poised to generate as much as $3 billion in new net interest income on a 100 basis point move in short-term rates.

Bank

BofA

Citigroup (NYSE:C)

JPMorgan

Wells Fargo

Price

$17.01

$52.27

$58.11

$46.39

Tangible Book

$13.79

$55.38

$40.81

$29.48

Price-to-Book

1.22X

0.94X

1.42X

1.57X

After its run, Bank of America is no longer trading at a discount to tangible book value. However, neither is it near the valuations of some of its peers. If it can get to 1.4X tangible book like peer JPMorgan Chase, the stock would have 13.5% upside opportunity. But in order to get there, it needs for these legacy demons to disappear.

Source: Bank Of America Must Exorcise Its Demons