After years in the doghouse, Bank of America Corp (NYSE:BAC) has become a hot stock again. BAC stock doubled from its low last summer to its recent high at $25. It seems investors are finally starting to forgive the firm for its grave errors during the financial crisis.
Investors had almost certainly undervalued BAC stock previously. However, by the time it hit $25 this winter, one could argue that it was rapidly heading toward overvaluation. Is the recent 10% dip enough to justify new positions here, or is it better to let this correction play out first?
BAC Stock Cons
Trump Trade Over? The American banking sector has surged since Trump won. A rising tide lifted all boats, and BAC stock has enjoyed the ride. However, the wave may be crashing now. Trump’s domestic agenda has seemingly run aground as the Republican’s much-hyped health care initiative failed and uncertainty remains for the tax overhaul.
Instead, the White House’s attention has turned overseas. With dual active situations now in Syria and North Korea, the domestic agenda has taken the back burner. Investors had bought banks thinking that Trump’s stimulus policies would get the economy growing more quickly.
Interest Rates Falling Rapidly: Banks were supposed to make wider profit margins as the economy sped up. The Federal Reserve had suggested that there would be three rate hikes this year, and that, in theory, it would be a big boon for banks. Their net profit margins would soar as interest rates finally normalized, and banks would have much more cash flow with which to buy back stock or pay dividends.
The 10-year treasury bond, the key indicator for banking profitability, surged from 1.5% to as high as 2.65% over the last year. However, over the past month, rates have headed sharply in the wrong direction. Since the last Fed hike, the 10-year treasury yield has plunged to 2.25%. The decline in interest rates has accelerated over the past week, as geopolitical troubles pile up. In times of war, people buy bonds. And that’s the last thing BAC stock needs if it is going to keep rallying.
Not a Great Bank: Bank of America stock is cheap compared to peers, as I’ll discuss below. However there is a good reason for that. The bank performed terribly during the financial crisis, and recent operational performance (as opposed to the BAC stock price) has been just so-so.
The investment banking business has lost momentum compared to peers. And overall revenues in investment banking have been sluggish with soft markets for bond and stock underwriting in recent quarters. Bank of America has a huge deposit base, which gives it more interest rate leverage. That’s good when rates are rising, but poor in the last month’s environment. And others argue the bank’s cost-cutting efforts haven’t gone far enough. To put it briefly, while bulls correctly say the stock is cheap, it’s not entirely without justification.
BAC Stock Pros
Still Undervalued Versus Peers: Despite the huge run in BAC stock, it still looks cheap compared to other too-big-too-fail American banks. That’s because the whole sector has surged in unison; Bank of America stock hasn’t moved in a vacuum.
At this point, excluding one-off costs, BAC is trading at a 15x price-to-earnings ratio, compared to a 21x peer median across the industry. Perhaps more impressively, the bank is at 1.2x tangible book value, compared to 1.6x for U.S. banks as a whole and almost 2x for the largest capitalization ones in the United States.
Improving Regulatory Environment: The financial crisis caused an overhaul in the American banking industry’s regulatory environment. From an arguably too hands-off approach prior to 2008, things swung dramatically in the opposite direction. It wasn’t all bad for Bank of America; the Dodd-Frank regulations hit smaller banks even harder than the too-big-to-fail ones, thus helping the bank’s moat somewhat.
That said, the benefits of the Trump administration’s proposed deregulation would help BAC stock significantly on the whole. One key proposed change would ease too-big-to-fail rules on large banks. If Tier 1 equity Bank of America held fell from 9% to 7% of its capital, for example, it would boost the bank’s ROE to over 10%. That threshold is widely viewed as the level separating good banks from mediocre ones. The Trump administration appears intent on giving banks the tool to amp up their loan generation and unleashing the excess reserves currently held at the Federal Reserve.
Berkshire-Hathaway Buying? Warren Buffett’s Berkshire Hathaway Inc. (NYSE:BRK.A, NYSE:BRK.B) has been a long-time investor in Bank of America. Buffett first invested in the firm’s preferred stock in 2011. However, he recently suggested that he would be inclined to swap that position for regular BAC stock in the reasonably likely event that it raises its dividend from the current 30 cents to 44 cents or greater. At that level, the common stock would pay a greater dividend than his preferred stock position.
In addition, he now has another reason to make a move on BAC stock. This week, Berkshire announced that it is meaningfully reducing the size of its position in rival Wells Fargo & Co (NYSE:WFC). Berkshire has already sold 7.1 million shares of WFC and will sell almost 2 million more shortly. This is necessary to keep Berkshire’s stake in Wells Fargo under 10% of the total company thus avoiding onerous government regulation. With that freed up capital, Buffett may turn his sights to a different player in the same industry. Bank of America would be a logical replacement given his recent commentary.
Verdict on Bank of America Stock
I’m no fan of large American banks. If I’m going to buy a giant bank, I’d rather pick one in a regulatory environment known for more prudence, such as Canada. However, if you are comfortable with Wall Street’s big banks, there’s a case for BAC stock here. It’s quite cheap compared to peers. It appears investors are still punishing it for the past crisis’ crimes to some degree. If Trump can get the reflation trade back on track, Bank of America stock should hit new highs later this year.
At the time of this writing, Ian Bezek held BRK.B stock. He had no position in BAC stock. You can reach him on Twitter at @irbezek.
