- Positive stress test results will be a major catalyst for the stock.
- A rising rate environment and a steepening yield curve are positive for banks.
- Valuation and fundamentals are still very reasonable on a historical basis.
Bank of America Corporation (NYSE:BAC) has been on a tear over the past year, up 40%. The predominant explanation for the rise has been progress on cost reductions and lower litigation risk. I submit to you that this is only the beginning. In the following sections I will lay out my bull case for the stock going forward.
(Chart provided by Finviz.com)
Stress tests will be a positive catalyst
Last year, BAC received Federal Reserve approval for capital distributions after passing the 2013 stress test. They implemented an over $10 billion share buyback plan and upped the dividend to an annual payout of $0.04 cents per share, giving the stock a 0.23% yield currently. I expect the company to pass this year's stress test with flying colors as well. If Bank of America does pass the test, the company will most likely increase the dividend and announce another share buyback program.
At present, BAC is not on an income investor's radar due to the fact the yield is still insignificant. Nevertheless, as BAC increases the annual payout and the yield rises, I expect income investors to begin buying up shares. Prior to the 2008 crisis, Bank of America had a dividend yield of approximately 3%.
The yield curve is steepening
The yield curve steepens when the gap between the yield on short-term bonds and long-term bonds increases. This makes the curve appear steeper. Banks borrow short and lend long. As the spread between the 10-year and 2-year bond yields widen, the bank's profit margins rise. The 10-2 year treasury yield spread is currently at 2.32%, and rising.
(Chart provided by Ycharts.com)
Another significant positive regarding a steepening yield curve is the fact it is a clue to the direction of the economy. When the yield curve steepens, it portends the economy is on an upswing.
BAC still looks cheap on a historical valuation and fundamental basis
BAC has a current price to tangible book value ratio of 1.2. Historically, BAC has traded for closer to two times tangible book value. This implies significant potential upside from current levels if the stock can simply return to historical levels. This data squares well with the historical price performance of the stock. EPS and profits have grown significantly over the past year as well.
(Tables provided by Scottrade.com)
Macroeconomic and geopolitical headwinds emerge
If something goes awry in China, Europe or the Middle East the markets as a whole will be negatively affected. No stock will be immune. The current 'wall of worry' seems to be growing taller. This concern is amplified by the fact the market is still near all-time highs. This is a potent combination.
Legal risks still remain
Bank of America has not yet put the entirety of the company's legal risks behind it. Legal challenges from investors in mortgages and mortgage backed securities could still prevail against the bank.
The housing market craters
With rates on the rise, the housing market could take a hit. The housing recovery is still in its infancy. It remains to be seen if the housing market can withstand higher mortgage rates.
Bank of America is still a solid buy right now. Although the stock has risen 40% over the past year, the bank is still trading significantly below its historical price to book ratio. Moreover, earnings continue to increase. EPS is expected to grow significantly this year and in 2015 as well.
Bank of America still has considerable upside potential, strong fundamentals and catalysts for growth. The bank has a fortress balance sheet and strong cash flow. This will provide the opportunity for additional share buybacks and dividend increases. The yield curve is steepening and the housing market is on the cusp of a full blown recovery.
Nonetheless, it is always prudent to proceed cautiously when the markets enter the summer months. I plan on scaling in to a position, buying on any dips. The stock may be sold off indiscriminately based on geopolitical or macroeconomic headwinds. My target price is $25 within the next twelve months.