Bank Of America More Undervalued Than Wells Fargo

| About: Bank of (BAC)

The state of current financials presents something of a poster child story for illustrating how emotional anomalies can substantially discount market values. At this point, inevitable value plays in the "high-risk" market appear destined for the Harvard case study booklet on behavioral economics. By almost any measure, the stocks are undervalued and they continue to underperform more general indexes. Over the last twelve months, Wells Fargo (NYSE:WFC) lost nearly 10% and Bank of America (NYSE:BAC) lost more than an egregious 50% while the Dow Jones (NYSEARCA:DIA) appreciated by 3.6%. Measured from five years ago, Wells Fargo has roughly two-quarters of its value left and BofA has less than a tenth of its value left. At what point does this tumble become ridiculous?

Despite what some "occupiers" might have you believe, the fundamentals of Wall Street firms and American banks are strong, rein supreme globally, and are a tremendous net positive to society. There will always be setbacks along the way to growing shareholder value, but this means very little in the grand scheme of things. As matters return to normalcy, irrational fears about over leverage and high betas will be set aside and replaced by, ironically, a level of respect for the banking foundations that have solidifed America as the top economic power.

From a multiples perspective, financials appear cheap. Wells Fargo trades at a respective 8.7x and 7.2x past and forward earnings, while offering a dividend yield of 2.04%. BofA trades at only a quarter of book value and 5.2x forward earnings, while offering a dividend yield of 0.77%. The high betas of both stocks will help to drive high risk-adjusted returns and the upside, in my view, is much greater than the downside, which has likely already seen its bottom.

Consensus estimates for BofA's EPS are that it will increase by 14% from 2010 to 2012, hitting $0.98, and then increasing by 35.7% more in the following years. Of the 7 revisions, all have gone up for a net change of 132.6%. Assuming an 8x multiple - a good amount below peers - and a conservative 2012 EPS of $0.85, the rough forecasted worth of the stock is $6.80. This implies a 30.8% margin of safety and more than justifies calling the investment a value play. Analysts currently rate shares a "hold," but I find it more of a "buy" since the company is taking the right steps to boost EPS and ROE.

In particular, management has improved the balance sheet by selling off some non-essential assets and exchanging high-risk debt. New shares have been issued to replace higher-cost securities, thus mitigating financial pressures. As credit spreads have gone up, this was a particularly opportune time to build capital and strengthen liquidity. In order to further improve efficiency, BofA has sold its stake in China Construction Bank for a net of $1.8B, as well as in other businesses.

Consensus estimates for Well Fargo's EPS are that it will increase by 27.1% to $2.81 in 2011 and then by 15.3% and 10.8% more in the following years. Of the 6 revisions, half have gone up. Assuming a multiple of 9x - a good amount below peers - and a conservative 2012 EPS of $3.16, the rough forecasted worth of the stock is $28.44. This implies an 18.4% margin of safety and does not justify calling it a value play. While improving credit trends, liquidity, and loan growth will benefit the firm, uncertain capital allocation policy, regulatory risks, and a weak transaction environment will hold back value at a vulnerable time. In October, the firm issued a net ~1.3M shares, which will limit EPS. In addition, Wells Fargo appears unsure about its share repurchase program going forward.

In conclusion, although analysts currently rate shares of Wells Fargo and BofA a respective "buy" and "hold," I believe that the reverse should be the case. The latter has a significantly higher margin of safety and is taking the necessary steps to grow EPS and return free cash flow to shareholders. Although Wells Fargo is still a strong company, I find more favorable risk/reward exists for its competitior at the present moment. With an improving Tier 1 common ratio and undervalued fundamentals, BofA, in my opinion, has tremendous upside and little downside. BofA has been unduly maligned of late and is in a strong position to get investors refocused on the big picture.

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Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BAC over the next 72 hours.