Bank of America: Why Now is a Good Time to Buy

Financials have trailed the general market by a large margin this year. The U.S. financial sector is down by 2.6% since the beginning of the year, while the S&P 500 is up 9.3%. Some legitimate concerns have been holding financial stocks back this year. It is likely that investors are anticipating that the cycle for investment banking income is at or near its peak. Additionally, problems in sub-prime lending have exposed how lending standards have deteriorated during the good times in recent years.

Of course, not all financial institutions are exposed to these factors to the same extent. As the whole sector has been dragged down in recent months, it could be a good time to look for banks that are not overly dependent on investment banking income and have reasonably conservative lending standards.

My approach here is to first look for financial institutions with attractive valuations and then find the ones that are least exposed to the aforementioned risk factors. For the valuation, I set up a scatter diagram with a five-year average return on equity on the x-axis and price / book value of equity on the y-axis. As we want to find banks with a high return on equity in relation to P/B, we focus our attention on the data points below and to the right of the trend line. Each dot on the graph represents a large bank (the smallest has a market cap. of around $15 billion). Most of them are North-American with a couple of European banks thrown in for good measure.

The four banks that are furthest from the trend line are Capital One Financial Corp. (COF), Bank of America (BAC), PNC Financial Services Group Inc. (PNC), and Wachovia Corp. (WB). These may all be potentially good opportunities worthy of further inspection, but I will single out Bank of America as an attractive buying opportunity.

Bank of America has a diversified income stream and is rather conservative as banking institutions go. It has a great source of funding with by far the largest deposit base of U.S. banks and is neither overly dependent on investment banking income nor mortgage lending (although those are two of the bank’s primary growth opportunities). With a five-year average ROE of 18.9%, Price to Book of 1.6, and 10.3 times trailing earnings, it seems very attractively priced.