Conflicting Outlooks On Bank Of New York Mellon

Summary

• BK has a low total return over the past 15 years.
• Current valuation is reasonable, with a forward P/E of 12.
• Wall Street consensus outlook is bullish, with 5%-7% 12-month price appreciation.
• Market-implied outlook (derived from options prices) is somewhat bearish.
• I am compromising on a neutral rating for BK, but selling covered calls is worth considering.

Bank of New York Mellon (NYSE:BK) is a global financial services company, the world’s largest asset custodian, and the seventh largest asset manager. While the stock price has rallied so far in 2021 (largely due to rising interest rates), the last decade and a half has been fairly dismal. Even after rallying strongly from the COVID-driven decline in 2020, the stock price remains 6.8% below its January 7, 2020 close of $51.25. The current share price is also 16.5% below high closing prices from mid-2018.

Price history and basic statistics for BK (Source: Seeking Alpha)

The forward P/E of 12.01 and the forward dividend yield of 2.58% are reasonable. The 3-5 year consensus EPS outlook is for 10.95% growth per year. The 5-year dividend growth rate is 12.77% per year, with a 31.4% payout ratio so the dividend looks very sustainable. BK is also planning to resume buybacks in 2021, which will drive up the share price.

Trailing total returns for BK vs. Asset Management sector and U.S. stock market (Source: Morningstar)

The trailing total returns for BK are substantially below those of the Asset Management sector (and the market as a whole) for the past 3-, 5-, 10-, and 15-year periods. The trailing returns also lag the Invesco KBW Bank ETF (KBWB), in which BK is the 7th-largest holding (with an allocation of 4.25%).

Rather than provide my own projections for BK, this post discusses two consensus outlooks for the stock. The first is the Wall Street analyst consensus rating and 12-month price target. The second is the market-implied outlook, which is a probability distribution of price returns that are implied by the current prices of call and put options on BK. I also discuss the relative attractiveness of covered call strategies, given the market-implied outlook.

Wall Street Analyst Outlook

eTrade’s consensus outlook combines the view of 8 ranked analysts who have provided ratings and price targets for BK in the last 90 days. The consensus rating is bullish and the consensus 12-month price target is 6.93% above the current price. The lowest of the analyst price targets is only 1.24% below the current price and the dispersion among the analysts is quite low.

Wall Street analyst consensus rating and 12-month price target for BK (Source: eTrade)

Seeking Alpha’s calculation of the Wall Street consensus includes 19 analysts who have provided ratings and price targets in the last 90 days. The consensus rating is bullish and the consensus price target is slightly lower than in eTrade’s consensus calculation, 5.25% above the current share price. None of the analysts assign anything less than a neutral rating.

Wall Street analyst consensus rating and price target for BK (Source: Seeking Alpha)

The prevailing ratings for BK have become markedly more positive since mid-2019. There was a 5-month period when no analysts were Very Bullish. Today, 7 out of the 19 are Very Bullish.

Percentage of Wall Street analysts at each rating (Source: Seeking Alpha)

Market-Implied Outlook

The market-implied outlook is the expected probability distribution of price returns derived from the prices at which call and put options are trading. Options traders are betting on the probability that the stock price will rise above (calls) or fall below a specific level (the strike price) over a period of time (from now until the option expiration date).

By analyzing options prices at a range of strikes but the same expiration, it is possible to calculate the probabilities of all possible future returns that will reconcile the prevailing options prices. The concept of a market-implied outlook is fairly mainstream in quantitative finance, but is less well-known among individual investors. For those who are interested, I have written an overview post that provides examples and links to relevant finance literature and an implementation of market-implied outlooks by the Minneapolis Federal Reserve Bank.

I have analyzed put and call options at a range of strikes and the same expiration date, January 21, 2022. The market-implied outlook provides the probabilities of price returns for the period from now until that date, a 9.5 month period. The standard presentation is in the form of a probability distribution of return, with probability on the vertical axis and return on the horizontal axis. It is immediately notable that the peak probabilities are shifted towards negative returns.

Market-implied probabilities of price returns for BK for the period from now until January 21, 2022 (Source: author’s calculations using options quotes from eTrade)

To make it easier to see the relative probabilities of positive and negative returns, I typically rotate the Negative Return side of the distribution (the area to the left of zero return) about the vertical axis (see chart below).

Market-implied probabilities of price returns for BK for the period from now until January 21, 2022, with negative returns rotated about the vertical axis (Source: author’s calculations using options quotes from eTrade)

There is an elevated probability of negative returns vs. positive returns of the same magnitude (the red dashed line is above the solid blue line) for a wide range of returns. This is a bearish outlook. The median price return is -3.5% and there is a 55% probability of having a price return less than or equal to zero. The highest probabilities are for returns ranging from +2.5% to -15% over the next 9.5 months.

The annualized volatility derived from the market-implied return distribution is 32%.

In recent analyses of other banks, I have found covered call strategies that provide a high level of income while still retaining some potential for price gains. See, for example, my analyses for USB and for C. BK is also worth considering for covered call selling. This morning, I executed a covered call position on BK, buying the shares at $47.62 and selling the January 21, 2022 call option with a $55 strike. The calls sold at $2.05 per share, for an option premium yield of 4.3% ($2.05 / $47.62).

With an expected 2.58% dividend yield over the next year and the 4.3% option premium yield over the next 9.5 months, this net position should provide 7% or more in total income over the next 12 months, as well as retaining 15.5% in potential price appreciation (the maximum price gain before the price of BK exceeds the option strike price and the call buyer is likely to exercise the option).

The last dividend payment was on February 12th, so holding this stock for the next 12 months should provide four quarterly payments. Even without selling another covered call after the current options expire on January 21, 2022 and assuming no dividend growth, the total income for the next 12 months would be 6.88%.

Summary

Bank of New York Mellon has provided poor returns over the past 15 years. Rising interest rates should give the stock a boost, as will the anticipated resumption of buybacks. The consensus of Wall Street analysts is that the stock can expect 5%-7% in price appreciation over the next 12 months. In combination with the well-supported 2.8% dividend yield, this puts the expected total return at 8%-10%. For a stock with an expected volatility of 32%, this is a decent return.

The market-implied outlook is somewhat bearish, with an elevated probability of negative returns relative to similar-magnitude positive returns. The median price return is -3.5%. In the market-implied outlook, there is a 36% probability of having a price return greater than or equal to 5% and a 32% probability of having a return less than or equal to 8%. In other words, the analyst consensus price targets look high but are within the range of plausible outcomes.

My final overall rating for BK, a compromise between the bullish analysts and the bearish options traders, is neutral. For those inclined to go long BK, a covered call strategy can provide significant total income while still retaining considerable upside potential.

Analyst’s Disclosure: I am/we are long BK. 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.

I have sold covered calls on BK as described in this post.

Comments

[cfgh]

I own BK and a few other big banks. The question is why not move the money to another stock with similar risk and better returns. BK is good, but is there a better option in the sector?

[User 180692]

Hold right now.

They should sell the asset management business.

[markustv]

Geoff, thank you for another fine article. How do you think about shorter term covered calls? Where do you see the benefit of the Jan 22 expiration over a trade that would only reach out for the next 4 weeks or 6 months rather than 9 months?
Greetings

[Geoff Considine]

@markustv I have not specifically examined the shorter-term options for BK. In general, however, with the Jan 2022 outlook and the analyst consensus, nothing would deter me from considering shorter-term positions. There is obviously more turnover if you are considering doing a series of shorter-term covered call sales and that has implications for the costs you incur on the bid-ask spread. Options tend to have wide bid-ask and, as such, you pay a penalty each time you trade.

Thanks for the comments.

[Herbert 5223]

BK needs to add a few other revenue generating product areas that also generate a 12% risk adjusted ROE in order to have a PE ratio more like a regional bank growth stock. At this point, I consider BK to be more like a money market fund dressed up as a bank. Low earnings growth but very low risk.

[Geoff Considine]

@Herbert 5223 The option implied volatility, which is best source for volatility expectations, is not especially low for BK (32%), so I don't see this low risk. That said, it would be very odd if one could realize 7% in income from a very low risk bet...

[Herbert 5223]

@Geoff Considine the pandemic increased all equity vols but the market seems to rectify that over time and differentiate the banks based on the true earnings exposure to the pandemic.. There will be some volatility in BK but it is related more to the systemic volatility of the equity market in general. Since BK’s business model is such low risk, the vols are needlessly overstated in my view and BK should be bought on significant dips. (My entire career has been in derivatives)

[Geoff Considine]

@Herbert 5223 You raise a good point here with regard to equity vols being elevated across the market and somewhat indiscriminately. This is part of what makes selling options look so attractive right now. I am not betting on the options being over-priced but my portfolio is intentionally positioned to benefit if they are. In my experience, quant models typically have a strong decay factor in how they weight trailling volatility into forward looking estimates. As such, it makes sense that vol was over-stated when we were near the COVID market drop in early 2020, but I would have expected the effect to have decayed away more than it has.