In the classic investment book, The Intelligent Investor, Benjamin Graham stated,
If we assume that it is the habit of the stock market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue, relatively at least, companies that are out of favor because of unsatisfactory developments of a temporary nature. This may be set down as a fundamental law of the stock market, and it suggests an investment approach that should prove both conservative and promising. The key requirement is for the enterprising investor to concentrate on the larger companies that are going through a period of unpopularity.
If ever there was a representation for everything that is unfavorably impacting the financial services industry and exceedingly unpopular with investors, Bank of America (BAC) is a most suitable example. As the largest bank holding company in the U.S. with assets of $2.26 trillion and total deposits of $1.038 trillion as of June 30, 2011, Bank of America’s troubles began when it purchased Countrywide Financial, a large mortgage banker, for $4 billion in 2008.
Bank of America inherited approximately $1.5 trillion of legacy mortgage loans that were originated by Countrywide during the period 2004-2008. The non-performance of some of these mortgages has led to an overhang of numerous lawsuits from a vast array of institutional investors and government-sponsored enterprises (GSEs) that have sought claims against Bank of America to repurchase and make them whole due to alleged breaches of selling representations and warranties. The cloud of uncertainty surrounding the ultimate liability to Bank of America has driven the price of its share price down by more than 45% year to date.
Despite the enormous task to comply with regulatory banking capital standards and resolve legacy residential mortgage issues, Bank of America’s management team has made significant progress in achieving balance sheet liquidity through the sale of non-core assets and the negotiation of multiple settlement agreements to resolve repurchase claims involving first lien residential mortgages. As of June 30, 2010, Bank of America had approximately $120 billion in cash on the balance sheet, which is nearly twice the $70 billion market capitalization for the bank.
Tangible book value (shareholder’s equity minus goodwill & intangibles) currently stands at $12.65 per share, which is nearly twice the current share price. Tier 1 Capital has grown by 60% since 2009 and deposits continue to roll in at a steady rate. Bank of America has already paid $12 billion in mortgage related settlements and has reserved an additional $18 billion for potential future claims. Although the company has not settled all outstanding lawsuits, claiming misrepresentation and failure to perform due diligence for legacy loans, it is prepared to aggressively defend their position that investors were sophisticated to know the risks associated with such private label securitizations.
Since January of 2010, five of the six business segments at Bank of America have generated net income that has averaged $4.5 billion per quarter. Since 2001, Bank of America has earned an average of 1% on its assets and in excess of 10% on its equity capital. These ratios would indicate future earnings power of approximately $2.00 per share. By applying a 25% discount to its historical average price/earnings ratio of 10X, one can make the case for a $15 price target once the mortgage related issues are resolved.
The strength of Bank of America’s balance sheet position has improved dramatically over the past two years in terms of increased liquidity and available capital to absorb losses. Despite the uncertainty and unpopularity related to the remaining legacy mortgage related issues, Bank of America is an attractively priced business that is capable of providing a satisfactory rate of return for shareholders.