With its stock encountering resistance around $8/share after a 60% rally from its 3-month lows, it is a good time to revisit the investment thesis for Bank of America (BAC). Has the stock run out of steam or is it about to breakout? With signs of an improving economy, I feel that Bank of America is still an attractive buy, because it still trades at a significant discount to its peers.
Bank of America: Still Cheap
Bank of America currently trades at an attractive entry point of $8.02, which is 3% above its 50-day moving average. The stock has risen 20% year-to-date and 60% from its 3-month low. Yet, the stock still trades at a discount to its book value and to its peers. Here is a comparison of price-to-book metrics for major money center banks Citigroup (C), JPMorgan (JPM), Wells Fargo (WFC), Goldman-Sachs (GS), and Morgan Stanley (MS):
P/B | ||
Bank of America | 0.4 | |
Citigroup | 0.6 | |
JP Morgan | 0.9 | |
Wells Fargo | 1.2 | |
Goldman-Sachs | 0.9 | |
Morgan Stanley | 0.6 | |
Average | 0.8 | |
(Financial data source: Yahoo!Finance)
Bank of America trades at a P/B of 0.4 versus an average P/B of 0.8 for large financial banks, implying a potential valuation upside of 100%. Bank of America can thank Ken Lewis for weakening a pristine balance sheet with purchases of Countrywide and Merrill Lynch. The current CEO Brian Moynihan has done a good job cleaning the balance sheet. Now the firm just needs a stable or improving economy to provide the tailwind that closes the valuation gap.
The Global Economy Shows Signs of Stabilization
The prospects of a global economic recovery have increased significantly in recent days. Yesterday, Europe provided some positive news about successes in containing the Greek debt crisis. Today, we await additional data points on U.S. employment. Increasing clarity into the 2012 economy positively benefits Financials in general and Bank of America in particular.
Loan-loss Reserves Decline as Economy Improves
Bank of America borrows money for short periods of time and lends that money for longer periods. From a risk-perspective, Bank of America's balance sheet is equivalent to a portfolio of bonds on margin. If your margin account falls below its collateral limit, your broker will require that you post more collateral. This is known as the dreaded margin call. Similarly, if Bank of America's capital ratio declines, federal regulators will require the bank to raise capital.
Currently, Bank of America is not in danger of a margin call by the Fed. Bank of America would have to absorb a fairly significant set of loan losses -- roughly a 10% decline in Long-Term Investments-- to wipe out its book value. A balance sheet deterioration of this magnitude is possible if there is a severe recession. In a recession, default rates rise and banks will have to write down loans. Absent a recession, Bank of America's financial position will likely improve considerably, as the expected losses from its loan portfolio dramatically decline. In fact, a positive catalyst for the shares is the continued reduction of Bank of America's reserves for loan losses over the coming quarters.
Balance sheet deterioration is also possible if the management has very poor risk management procedures. With regulators scrutinizing the bank's loan portfolio, the recession risk is substantially greater than a mismanagement risk.
Conclusion
Bank of America's toughest days seem to be behind it, and the patient appears to be in stable condition. As the economy improves, the stock price will begin to march toward its book value. Given the steady stream of positive economic data points, I see Bank of America's current price of $8 as a compelling entry point.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BAC over the next 72 hours.
