- Bank of America was severely wounded by the financial crisis and its acquisition of Merrill Lynch and Countrywide. Their turnaround has progressed nicely.
- Much of the repair to the balance sheet is done: now it’s a matter of realizing their true earnings potential. Perhaps achievable in the coming five years.
- Over the coming ten years I expect Bank of America, together with its crisis acquisitions to emerge far more powerful than ever before.
- The stock is attractively priced - it trades at a 24% discount to book value and a 15% premium to tangible book value.
Earnings season is upon us. And with reports due from Goldman Sachs and Bank of America (NYSE:BAC) due on April 17th and April 16th respectively, this is an interesting time because we always see a price response to earnings expectations in the lead up to earnings, with potential for further volatility when expectations adjust based on new information available. When there is a price response, there is an opportunity to benefit from a price/value arbitrage.
In this post I express my perception of Bank of America's Value, and hopefully leave enough information to allow readers to form their own view on the value if they are so inclined.
Bank of America was severely wounded by the financial crisis, and its acquisition of Merrill Lynch and Countrywide. Their turn-around has progressed nicely, and at present I see no risk to their ability to survive: there were no mortal wounds inflicted by the crisis. In fact I see Bank of America as a solid turn-around candidate, where the risk is considerably lower than it was a few years ago. Much of the repair to the balance sheet is done: now it's a matter of realizing their true earnings potential which lies far above current earnings. I am looking for a completion of the turn-around in the coming five years, and expect Bank of America, together with its crisis acquisitions to emerge far more powerful than it has ever been in the next ten years.
The market is expensive and the risk at Bank of America is perceived as high, yet to me it represents a long-term buy. The stock trades at a substantial discount to book value of $20.71 per share. It is priced to buy to allocation for an investor seeking a long-term return of 12.32%. And if the market weakens, it might make sense to add positions should the stock approach its tangible book value of $13.79.
How do different market participants view Bank of America?
A couple of years ago, I had written some code to facilitate stock selection. You can view the model output here. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better.
AOM Statistical Scores
The AOM statistical scores are a statistical evaluation of thirty-eight key indicators for the company, grouped into value, growth, quality, and momentum categories. It illustrates how the key indicators for the stock, perform in comparison to the market capitalization weighted scores for the market, the stock's sector and the stock's industry of operation.
Bank of America scores high on value, in comparison to the market as a whole, and in comparison with stocks in its sector and industry of operations. It scores high on growth too. The score for quality and momentum remain weak.
Source: Alpha Omega Mathematica
AOM Model Recommendation
The stock might appeal to value investors who seek to allocate capital to the sector, and to those with no capital allocation bias. It would also be of possible interest to the balanced investor who gives due consideration to a broad variety of indicators, and weights the value, momentum, growth and quality groups equally. Others remain neutral to Bank of America.
Source: Alpha Omega Mathematica
Overall, after analyzing fifteen stock selection and capital allocation strategy combinations, the system assigns an AOM Score of 57% and an AOM Hold Recommendation for Bank of America.
The AOM statistical scores for each of the fifteen strategy combinations are unique and not comparable with each other. The AOM Score is very different from AOM Statistical scores: it evaluates and rates the AOM Statistical scores for each of the fifteen strategy combinations, and uses a unique technique to make the statistical scores across the strategy combinations comparable. The output is the AOM Score: a quantitative assessment of the output from the fifteen strategy combinations. The AOM Recommendation is a plain English recommendation based on the quintile the AOM Score falls in.
I'll hasten to add that this is a package aimed at generating ideas, it does not intend to, and nor does it replace the due diligence we must do as investors. It is a tool which uses quantitative techniques to understand the behavior of different market participants, and then brings that data together so that users can hear the voice of the market through the noise. The AOM system can guide you where to look, but make no mistake about it - it cannot look for you.
The Case for Bank of America:
Why look at Bank of America now?
Based on the Federal Reserve Board approval, and Bank of America's own estimate of 9.96% for the Basel III Tier One Capital ratio under the advanced approach, it does appear that Bank of America will not have problems in meeting the new Basel III regulatory requirements. The SLR at Bank of America is likely strong enough to satisfy proposed U.S. regulations, which might lead to the SLR for the top eight U.S. Banks being raised to 5% for the Holding Company and 6% for Insured Subsidiaries. Fitch said that Bank of America expects to be in compliance with the supplementary leverage ratio [SLR] at the holding company and its two insured subsidiaries. Though I suspect there will be a small impact on the capital plan to strengthen the SLR. And this suggests they are safe.
We know that after the Federal Reserve Board approved their revised capital plan, Bank of America will hike the quarterly dividend to $0.20 per year. This will provide investors a yield of 1.24%. In addition, the Board authorized a stock repurchase plan of $4 billion: about 2.3% of market capitalization. If nothing else, this will be a pleasant change from the heavy dilution suffered by shareholders these past five years. After all over the past five years, average annual diluted shares outstanding have climbed 48.69% in total. The approval of a $4 billion buyback plan suggests that further dilution other than that caused by issuances to employees is less likely. When the company reinvests in growth, one of the key areas of investment is employee incentive and retention. If part of earnings are earmarked for investment in employees, and is provided via share grants and options, then when shares are issued to employees, we will have a dilutive event. And when a buyback program is raised to offset the dilution, it does not constitute a return of shareholder value. It represents the payment of consideration on account of an investment in growth. While the buyback plan does not represent a return of shareholder value, it will limit the impact of dilution as a consequence of employee issuances. More importantly, it signals that further capital issuance to repair the balance sheet is less likely.
Historic earnings these past few years have been poor at Bank of America mainly because of the crisis acquisitions of Countrywide and Merrill Lynch. This has extracted a terrible price from owners. There may be more to pay, but the journey towards realizing the full potential earnings has begun. History does not matter. Nor do analyst estimates. What does matter is potential earnings, and when they might be reached. In my view, potential earnings of $2.07, assuming a 10% return on book value is a reasonable estimate of potential earnings today. This represents about 15% of tangible book value, which is also consistent with industry return on total tangible equity capital employed.
Beta, co-efficient of determination and alpha intercept considerations
Value-line reports a beta of 1.70 for Bank of America. The value-line beta is calculated as a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge towards one.
I calculate the raw beta based on the five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the S&P 500 at 1.92, and I adjust it to 1.62 on account of the beta's tendency to converge towards one. An alternative adjusted beta, which takes a view on the coefficient of determination for a stock provides a beta estimate of 1.36. This beta of over one can be constructive in a rising market and destructive in declines, thus, it cannot be said to possess defensive characteristics.
The good news is that the beta at Bank of America is showing an inclination to converge towards one rapidly. When I look at the raw beta based on the three-year regression of weekly closing prices of the stock, relative to weekly closing prices of the S&P 500, I arrive at 1.75, and I adjust it to 1.50 on account of beta's tendency to converge towards one. When I look at the raw beta based on the one-year regression of weekly closing prices of the stock, relative to weekly closing prices of the S&P 500, I arrive at 1.30, and I adjust it to 1.11 on account of beta's tendency to converge towards one. What this means is that investors today, stand to benefit from alpha, caused by a subsequent decline in beta.
When we look at the make-up or components of alpha, it is clear that the market return and risk free rates are uncontrolled by investors. It is equally clear that investors cannot influence the beta. Therefore, the question is what does influence beta? There is more detail on both alpha and beta in this post. In my view, the key factors that influence beta are business mix, financial leverage and the market's perception of leadership quality. If a change in any of these factors can be reasonably expected, the beta will change. When it does change, the perception of risk associated with the security versus the market also changes. And as the perception of risk changes, returns demanded by investors change. This provides a massive opportunity to generate abnormal returns, or alpha.
In the case of Bank of America, significant improvement in the capital structure, and higher confidence in leadership capability are good reasons for a beta contraction.
I am looking for a five-year forward beta of 1.20 for Bank of America, and I will use a beta estimate of 1.36 to evaluate Bank of America.
Cyclicality and Bank of America
In my view, the U.S. economy is getting ready to shift from mid-cycle to late-cycle conditions. And during late-cycle, no discernible pattern is evident for stocks in the financial services sector. In my view, the late-cycle conditions are associated with a flattening of the yield curve, and even an inversion towards the end of the late-cycle. If I am right, this is negative for Bank of America investors, but it is a positive for potential investors in Bank of America, because late in the late-cycle and early in the recession is a time when a buy opportunity often, but not always, arises. And coming on the heels of a recession is the early-cycle: a period when the financial services sector tends to outperform very substantially.
You can have a look at this information from Fidelity here to understand their take on sectors and the business cycle. One note of caution: I find reading the business cycle is getting increasingly difficult with globalization - for instance, today, I think U.S. is exhibiting classic signals of a move towards late-cycle conditions. However, the global business cycle is quite out of sync with the U.S. business cycle. And since many U.S. companies are very influenced by the global business cycle, it is more difficult to figure out how U.S. sectors will behave. For example, if Europe, other developed markets, or emerging markets shift into early-cycle conditions, this is a time when the financial services sector typically outperforms, and U.S. companies in the financial services sector could well outperform too.
Analyst price expectations
Recently Bank of America traded at $15.81. From Yahoo Finance we know that twenty-nine analysts expect an average price target of $17.56 (median $18.00), with a high target of $21 and a low target of $8.68. This is a wide dispersion in expectations, which suggests risks are high. It is early in the year. So far, the bulls looking for $17.56 have the upper hands over the bears looking for $8.68.
We might believe that Bank of America is attractively valued. But thus far, its attractiveness has been viewed relative to other stocks in its sector, industry or the coverage universe in the analysis of the perception of different market participants. We also know that Bank of America is cheap relative to the broad markets. What we do not know is whether the stock is priced to deliver a long-term return in-line with our long-term expectations on a stand-alone basis and regardless of broad market valuations.
Mathematically, the worth of Bank of America is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].
What is our long-term return expectation for a stock with a beta of 1.36, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk Free Rate plus Beta Multiplied by Market Return less Risk Free Rate. Thus for Bank of America, we should be targeting a long-term return of 12.32%. Is the stock priced to deliver that return?
What are our estimates for earnings? Twenty-five analysts included on Reuters data estimate average earnings of $1.09 (High: $1.24, Low: 0.97) during the year ended December 14, while twenty-nine analysts estimate that it will rise to an average of $1.60 (High: $1.93, Low: 1.24) for the year ending December 15. Three analysts assess long-term growth rates at 15.46% on average, with a high estimate of 29.39% and a low estimate of 5%.
How much value do we expect Bank of America to return to shareholders? In the long-term, I expect Bank of America will pay-out approximately 15% of earnings via a dividend, and 20% via buybacks. That will leave 65.00% available for reinvestment in growth. This 65% of retained profit re-invested at a 10% return on equity, indicates a long-term potential growth rate of 6.50% (65% * 10% = 6.50%). This return on incremental equity is not unreasonable to expect.
The buyback program is likely to be in excess of 20%. However, the excess will not constitute a return of shareholder value. The company retains 65% to reinvest in growth, and one of the key areas of investment is employee incentive and retention. If 15% of earnings are earmarked for investment in employees, and is provided via share grants and options, then when shares are issued to employees, we will have a dilutive event. And the buyback program could be raised to offset the dilution. But this element of the buyback program is not considered a return of shareholder value. It represents payment of consideration on account of an investment in growth.
But what are sustainable earnings? For the year ended 2013, Bank of America earned $0.90. And that amount is well below earnings potential of $2.07.
I view Bank of America as a low risk successful turn-around story. So what I would like to do is value where I see the company five years down the road, and discount that value to the present time.
Assuming that book value per share rises at an annualized rate of 10% over the coming five years, we can expect to see book value at $33.40 by December 2018. By December 2018, I fully expect Bank of America to have completed a successful turn-around. By that time I would expect earnings per share of $3.34, which represents a 10% return on equity (10% off estimated book value in 2018 of $33.40). And by then I expect Bank of America's beta to have contracted to 1.20. A beta of 1.20, assuming a risk free rate of 4.5%, and an equity risk premium of 5.75% will indicate investor return expectations of 11.40%. And since the hard work of growing earnings to the potential earnings target will be complete, I will expect the long-term earnings growth rate to return to 6.5%.
Mathematically, the worth of Bank of America is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate]. Thus the value of the share in five years can be expected to be $25.41 (106.50% * $3.34 * 35%/(11.4%-6.50%).
Based on my present estimate of beta, I seek an annualized total return of 12.32%. Over 2014 to 2018, I expect to collect an estimated $1.94 in dividends (including dividend growth as the banks recovery accelerates). This $1.94 has a present value of $1.33 using a discount rate of 12.32%. Based on the recent share price of $15.81, the dividend gives me a total yield to cost of 8.43% ($1.33/$15.81), which represents an annualized return of 1.63%. Thus, I should target a return from price gains of 10.69% (12.32% less 1.63%). I expect the shares to be worth $25.41 in December 2018, approximately 4.72 years from today. Discounting $25.41 to present value using a 10.69% discount rate I get $15.73 ($25.41 * 1/110.69^4.72). At this price the stock is a buy for a buyer targeting a long-term total return of 12.32% (10.69% via price gains and 1.63% via dividends).
The $25.41 represents my perception of value. If the potential earnings for 2019 are $3.55 ($3.34 * 106.50%), the share would be trading at a Forward PE of 7.14. The price could easily soar over value and approach $35 to $36.
There is upside to value too. In my calculations I have used an adjusted payout ratio of 35%: it could approach 50% as the financial services sector completes its recovery from the crisis. If it does, value in 2019 would rise to $36.30 (106.50% * $3.34 * 50% / (11.4%-6.50%).
And then there is time value. There are reasonable odds that Bank of America will approach potential earnings faster than five years. And there are reasonable odds that Bank of America including its crisis acquisitions will emerge stronger than ever before in less than ten years. This matters: the faster it happens, the higher the annualized gain!
The market is expensive and the risk at Bank of America is perceived as high, yet to me it represents a long-term buy.
If you use the above formula, do read this explanatory note.