By Michael Vodicka
The Federal Reserve has been teasing the market with an interest rate hike for most of the last five years. Finally, it looks like the most powerful central bank in the world is ready to make good on its promise. And while that may be considered a threat to industries that rely on cheap cash, it would be a $1.5 billion profit trigger for one of the four largest banks in the United States. Let me explain.
Expectations for a Fed rate hike in December recently spiked to a multi-month high.
The Federal Funds Futures, a contract traded at the Chicago Mercantile Exchange that calculates the probability of a rate hike, just hit a multi-month high of 64%.
Minutes from the Fed's September 20-21 meetings reveal that its 7-3 vote to leave rates unchanged was a "close call" and that voting members planned to raise rates "relatively soon." Both of these indicators point to a high probability that the Fed will finally pull the trigger on raising interest rates before the end of the year.
For industries such as real estate and building that rely on low interest rates, this isn't great news. It threatens to restrict the easy flow of cash into the hands of businesses and consumers.
However, a rate hike would be a profit trigger for one industry.
The banking industry becomes more profitable when interest rates rise because of something called net interest margin. Net interest margin is the difference between the cost of borrowing and lending money. When interest rates increase, net interest margin expands, making banks more profitable.
Right now, with U.S. interest rates near a record low, net interest margin has fallen to an all-time low. Take a look below.
Slumping net interest margin has been a huge profit drag on the banking industry. U.S. banks have had to cut expenses to the bone and maximize productivity for the last few years to grow profits.
Any growth in net interest margin would be a profit trigger for the entire banking industry.
For example, a 0.25% rate hike is projected to generate an additional $1 billion in annual profits for JPMorgan (NYSE:JPM). Citigroup, Inc. (NYSE:C) and Wells Fargo & Co. (NYSE:WFC) would also gain hundreds of millions in extra profit every year.
That's why this could be the best time to invest in bank stocks in the past five years. Investors want to buy the banking sector when net interest margin is near a cycle low and sell when it hits a high.
However, while most banks would benefit from a rate hike, one bank would benefit more than any other.
In fact, a marginal 0.25% increase in the Fed Funds rate would increase this bank's annual profit by $1.5 billion.
Bank of America (BAC) should be a familiar name. It's one of the four largest banks in the United States. After rebounding nicely out of the Great Recession, Bank of America's share price has been range bound for the past three years.
Today, I believe shares are headed for a long-term breakout because of the Fed's coming profit trigger. I believe that profit jolt would trigger capital inflows into Bank of America and lift shares out of the 3-year range and into a new multi-year high.
Even if the Fed doesn't raise interest rates this year, there are three more reasons I expect Bank of America to be in favor with investors.
Bank of America Is The Most Undervalued Company In An Undervalued Industry
The S&P 500 is trading with its highest P/E ratio in five years. It's difficult to find value in the largest companies in the United States. Banking is the exception.
The banking industry P/E ratio of 13 is a 28% discount to the S&P 500's 18. Bank of America is one of the most undervalued bank stocks. Its P/E ratio of 12 is an 8% discount to the industry average.
Bank of America Is Returning Billions To Shareholders
Bank of America is one of the most shareholder friendly banks and companies in the world. Since receiving approval from the Fed in the spring of 2015, Bank of America has been on a mission to re-grow its dividend, and in June the bank increased its dividend by 50% to $0.075 per quarter. Looking forward, I am expecting many more dividend hikes.
Bank of America is also showering shareholders with multi-billion dollar buybacks. The Board of Directors recently approved a $5 billion share buyback plan that will be executed in the next 12 months.
When you add dividends and buybacks together, Bank of America will be returning tens of billions of dollars to shareholders over the next two years.
Bank of America Continues To Capitalize On Online Banking
Bank of America is increasing profitability by capitalizing on the growing popularity of online banking. This past June, the bank announced it would cut 8,000 jobs from its consumer banking division. And last year Bank of America announced it would close hundreds of bank branches.
At the same time, Bank of America is investing billions into its mobile and online banking channels.
Investors cheered the moves. Since announcing its most recent round of layoffs in late June, Bank of America's share price has rallied more than 23% to a new 6-month high, as you can see in the chart below.
Risks To Consider: Out of the four banks, Bank of America is the most sensitive to interest rates. If interest rates reach a new all-time low or fall into negative territory, it would be an additional earnings drag on shares.
Action To Take: This is a good time to look at bank stocks and Bank of America in specific. Bank of America will benefit more than any other bank if the Fed raises rates. It's one of the most undervalued stocks in an undervalued industry and it is quickly re growing its dividend payment. Buy shares anywhere below $20.
This article was originally posted on StreetAuthority.com.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.