Last week in my Instablog I wrote a very short post on some additions after a hiatus from actively buying anything of size. I bought some Bank of America (NYSE:BAC). Obviously I must think it's cheap, and I must like it. The price continues to fall (which is not at all unusual in itself), though I'm wondering why? Am I the sucker? Who did I just buy from this morning? What do they know that I don't? How or why might they be constrained to sell?
Hence, this article begs the question: What Am I Missing?
This final question is not a rhetorical one. I'm genuinely interested in what the SA community might see that I don't - with one caveat: I'm not too interested in Moynihan bashing (without substance), stories of what BAC did to you in 2007-2009, or why I'm stupid to consider Bank of America.
In this short article, I'm not going to go into detail about what Bank of America does. As a ticker symbol, It's over-covered, over-bashed, and probably over-defended. All this information can be found on the numerous articles written about BAC elsewhere. In this article I am going to layout what I know, what I believe, and why. I have only one interest: The business and what might hurt it. I hope the comments section will turn into a dialogue with my article being the spark for the discussion and not the centerpiece.
BAC is not the same BAC it was in 2006, 2008, or 2010. Tangible asset to tangible equity has more than halved, insured mortgages has increased 3-4x, credit profiles on customers carrying credit has drastically improved.
Addressing the points above, I'll start with the last point first. From what I can see, the credit profiles have improved not only on the mortgage side, which has - up to this point - had a huge underwriting improvement, but the bank is also taking less risk on those borrowers having increased insured mortgages from 10% in 2009 to somewhere around 40% today.
If we look at their credit card customers in 2009, 16% had a FICO score under 620. Today that is well under 5%. To clarify the meaning of this, we know that FICO scores between 600 and 649 have a roughly 600% increase in delinquency rates compared to scores of 700-749. A big difference.
If we look at tangible assets to tangible equity ratio (a very opaque look at leverage) we see a pretty dramatic change. In 2007 this ratio was 27. Today it's less than half that (lower numbers are better).
The banks liquidity has more than doubled to ~$450 billion and debt has come down over $250 billion while the balance sheet has shrunk by some $600 Billion.
In 2015 the bank went through the DFAST and CCAR tests which determine the capital adequacy levels and capital planning process. If you've never taken a look at what's in these tests, it's interesting and probably worth your time. For example, the DFAST test implies the following: maximum quarterly annualized GDP decline is forecasted to be 6.1%, unemployment peaks at 10.1%, home prices decline 25.7%, equity markets decline 57.9%, and trough 10-year Treasury yields reach 0.9%. Although I don't want to see any of those scenarios play out, BAC passed. In regards to CCAR, the bank did initially have it's capital planning processes challenged (which mostly comprises of dividend and buyback plans/ability). This worried me less considering it might not be as closely tied to liquidity problems as would the DFAST test, and a resubmission would clear it up.
My investment thesis doesn't rely on rates rising. For someone as small as I, that be a foolish thing to bet on. With that said, BAC does have about 42% of assets that either re-price or mature within 3 months and only ~24% of assets re-price or mature in over 15 years. A fun (but possibly pointless) exercise is to imagine that, in conjunction with the above scenario, rates rise 3% over the next five years. That's an extra $4.4 billion after-tax with almost no added costs (there's not much expense to support rate increases at a bank). I'm not counting on or necessarily caring about this; it's simply interesting.
Also, over the past 10 years, deposits as a percentage of interest-bearing assets have increased about 10 percentage points to the mid 80's today.
BAC is far from perfect, and they're probably not the best-run major bank in America - although I do think they are run well. The bank's efficiency ratio at 68.5 for the entire group needs to come down further. It's trending in the right direction, but I think they've dallied on this a bit, although I'm not in any hurry to see them cut costs at the expense of their business. If we saw revenues rise, we'd also see this ratio look better. I'd also like to see improvement on ROA and ROE. The bank knows these things aren't where they should be, and the data is headed in the right direction for the time being.
What I think it's worth:
More than today. I don't know exactly what the business is worth and I've looked at it multiple ways. I do have an idea of the range to focus on. Partly because of this uncertainty, I apply a pretty handsome discount to the values I come up with.
Here are some ways I'm looking at it:
- Without any changes in interest rates we got net earnings of $17.1 billion when combining consumer banking (6.74 billion), GWIM (2,620), Global Banking (5,274), and Global Markets (2,506). This assume LAS under normalized business conditions is a zero. Using the risk free rate of 2%, equity premium of 5%, it gives us around a 14x PE (vs. 9.5x today). That's well over $22/share - still a discount to the overall market. I don't know if that's currently "fair" considering almost all major banks are trading at a discount, but it's something to consider.
- Tangible Book Value is $15.62 vs. today's price of $13.09. Book Value is at $22+. Looking at where the bank (and banks in general) trade in relation to these two values over the business cycle is telling. There's probably upside.
- I think there's a decent argument that even with the falling off of litigation costs and LAS expenses continuing the path they have since 2012, BAC could see pre-tax earnings in the 25-30 Billion range. One doesn't need a market multiple for this to be a good investment. 25-30 Billion pre tax at 11-13x earnings could be realistic over the cycle. This could mean $23+ per share.
- Piggybacking of the valuation in point 3, let's assume they get to the midpoint. $27.5 billion pre-tax giving them $19.5 billion in net income or $1.76/share assuming shares outstanding stays constant and a tax rate of 29%. Let's also assume the LAS expenses and the related take two more years to run-off. At a 12x multiple heading into 2018 the stock would be over $21 (29% annualized gains until then).
Of course there are other ways to value this. I hope to hear some of the ways in the comments. Because I think valuation is hard and the future is unpredictable, I'll take a 40% discount on what I think the business might be worth at normalized earning power. Doing this for the four points above then averaging that 40% discount gives me about $13.70. The stock's at $13.09 today. Implying over a 60% upside.
Finally, I'll wrap up with one of the largest questions I have surrounding BAC. Which is what their true exposure would be if we see a turn in the credit cycle (due to anything really). This is first level thinking, and I don't know what the second level question is. Bank of America itself can't answer this question with accuracy, but it's one that gnaws on me. The company is estimating their O&G losses would be minimal under their normal stress test scenarios - which are far from trustworthy (though perhaps that's just recency bias!). I'll continue to watch Moynihan closely, though I believe he'll continue his pace of cleaning house and shoring up the balance sheet.
Disclosure: I am/we are long BAC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.