After witnessing Bank of America (BAC) tear through a five-day, 20% run-up in price that capped a three-month return nearing 90%, many investors are rightfully skeptical of accumulating at these levels for fear of a whipsaw correction. As investors who tend to lean contrarian, we naturally share this skepticism. As a result, we decided to conduct an analysis of Bank of America at current price levels to help determine whether its stock can maintain recent momentum.
A Quick Look Back
It's been a tumultuous year for Bank of America, to say the least. Last March, the stock price was $14 and the $3 lows of '08 seemed a distant memory. By the end of spring, those memories came flooding back. A contagious European debt crisis, ongoing mortgage-related legal battles, slumping home prices, negative brand association, and a ubiquitous stream of general apocalyptic hysteria converged at once to drive irrationally low expectations for the entire domestic banking sector, Bank of America among the hardest hit. When the lows of 2008 were within reach in October, I initiated a long position and then went back to the well in December after a dip, making the simple calculation at the time that BofA would survive and was therefore oversold by any basic measure of valuation. The choice was clear for a value investor, made all the more so after Warren Buffett thought enough of the company to commit a $5 billion capital injection in August. My cost basis for BofA stands at $5.54, and it's obviously been a good ride.
So, too, did we add Bank of America to The Hedge Zone Model Portfolio earlier this month at a price of $8.02.
But with the short-term run-up in price, it feels like the character of our holding has been reshaped. At the very least, market expectations would seem to have realigned themselves to an extent that a reevaluation of the original investment thesis for Bank of America is necessary.
A Look at the Charts
To begin, let's look at what has happened over the past three months. The following is a chart comparing the three-month returns (excluding dividends) of Bank of America, Citigroup (C), JP Morgan (JPM), Wells Fargo (WFC), and the S&P 500:
BofA more than doubled the return of its peers during this three-month span and ran laps around the broader market. But if we look at a two-year chart, we see the recent outperformance in context--and it is far less impressive:
Over the last two years, Bank of America has severely underperformed in an underperforming sector. And, in fact, the recent 90%+ rally changed the technical landscape very little, even over this relatively short time span. But the real kicker is the five-year chart. Putting Citigroup aside, the relative underperformance of BofA is stunning and massive--as demonstrated below, BofA would need to gain over 500% tomorrow to achieve 5-year performance parity with JP Morgan and Wells Fargo:
Of course, stock performances over the past five years have mirrored actual company performances, and the fact is that Wells Fargo and JP Morgan have weathered the financial storm significantly better than Bank of America (or, for that matter, Citigroup). Particularly damaging to BofA was its high-profile acquisition of Countrywide Financial in January of 2008 and the numerous accompanying legal settlements involving unscrupulous Countrywide mortgage dealings. Since many of the legal battles are ongoing, their cost to BofA is unquantifiable and has been a significant drag on share price. The Countrywide acquisition also had the effect of over-exposing Bank of America to residential real estate at a time when the housing market continued to decline long after the equity markets were recovering.
Without actually addressing the issues that have plagued share price or whether the future is brighter for the bank, our judgment based on the chart and surface technicals is that BofA's massive underperformance relative to its primary competitors over the past five years indicates its share price should not be considered overbought following the recent run-up. In other words, it fell a long ways down, and, in turn, recovery would mean a long climb up. Of course, analyzing the charts alone cannot lead us to an adequate investment decision. We have to pair the technicals with the fundamentals.
A Look at the Numbers
In this section, we delve into the fundamental components of Bank of America, assessing its valuation and growth relative to its own potential and to its peers. The following table provides a fundamental breakdown of Bank of America in comparison to eight other banks and/or financial services providers:
Notably, BofA carries the largest discount to book value among its peers, as well as an extremely low price/sales ratio, bested only by Morgan Stanley (MS). Yet, BofA's yield falls short. At only 0.4%, it is in the lower tier of the group, besting only Citigroup and on-par with Capital One (COF). Meanwhile, U.S. Bancorp (USB), Bank of New York Mellon (BK), Goldman Sachs (GS), Morgan Stanley, JP Morgan, and Wells Fargo all boast annual yields of better than 1%, several well into the 2% range. For the banking sector, however, yield is a challenging metric right now given that the Fed is strictly overseeing the distribution of dividend payouts. Several banks, no doubt, would raise their dividends if granted permission.
Moving across the table to earnings, Bank of America with its diminutive 2011 EPS of $0.01 has clearly been lagging. The EPS contrast with rival banks is stark, but BofA's forward P/E of 8.64 is in-line with its peers. Granted, a short period ago, BofA's forward P/E would have indicated a steep discount to its peers, but the recent rally has established a forward P/E ratio parity. This parity would suggest that, absent earnings improvement, the recent outperformance could be coming to a close.
On the subject of management, we believe CEO Brian Moynihan is the right man for the job. He has done well by shareholders with his focus on internal strengthening; that is, he has committed the bank to achieving growth by integrating and expanding the many dynamic segments it already possesses as opposed to continuing the old habit of growing through aggressive acquisition. BofA's recent successful passage of the Fed's stress test is a testament to its improving fundamentals.
The bottom line is that we see challenges in Bank of America's numbers, but at the same time potential for improvement that would translate well into shareholder returns. We believe earnings upside follows from the following three potentialities:
1) Bank of America's various business segments, many of which are very strong in their own rights, mesh and operate more efficiently together;
2) The global economy enters a sustained bull market;
3) The domestic economic landscape achieves a state of relative normalcy, including a recovery in housing prices.
Indeed, there is reason to be optimistic in the short-term. The first quarter of 2012 has brought a booming global equities market that we would expect to boost wealth management revenue under the BofA Merrill Lynch brand. So, too, on this account should trading profits improve. Especially if the housing market shows any sign of following equities' lead, we expect BofA to report very favorable results in 2012.
When we first initiated a long position in Bank of America in October, our rationale was that survival would be enough for our investment to outperform. It is probably a good thing that this rationale is no longer sufficient in and of itself. We do, however, still find merit in the view that if Bank of America survives for the next five years, the price levels you are witnessing today will seem quite foreign in their depths. Given its leading portfolio of financial services and the substantial amount of untapped growth therein, it is our view that no major U.S. bank has quite the potential for outsized investor returns as does Bank of America.
In closing, we are still bullish on Bank of America, and, despite the ever-present threat of a short-term correction, made all the more threatening on account of recent rapid positive price action, we still believe you want to own Bank of America ahead of first quarter earnings. We are setting our price target at $16.