Year-to-date Bank of America (NYSE:BAC), stock is up 20%, which signals things continue to go well. As trade tensions rise again, though, it also is wise to be a little nervous about getting involved in BAC stock.
Bank of America stock is backed by a fundamentally robust business that also has various competitive advantages, such as new client growth potential, cost-cutting opportunities and capital return capacity that support the business and the stock price.
However, variables such as interest rates, economic growth, global political and trade worries and activity in the housing markets can impact a bank’s stock price.
Although I like Bank of America shares for a long-term diversified portfolio, I expect market volatility to continue in May. In case of further pullbacks in BAC stock in the coming days, investors may consider buying into the shares.
Here is why…
Global Business and BAC Stock
On April 16, Bank of America reported Q1 2019 financial results that beat expectations. Profit rose 6% to $7.3 billion. Earnings per share of 70 cents was also better than the consensus estimate of 66 cents.
As a global and universal bank, Bank of America has a diversified revenue base just like many of its peers, such as Citigroup (NYSE:C) or JPMorgan (NYSE:JPM). As the nation’s second-biggest bank by assets, the group operates in several segments, including consumer, business, and global banking, real estate services, wealth management, and global markets.
Core banking activities contribute to the revenue the most. Global banking and global markets businesses serve clients under the name “Bank of America Merrill Lynch.” Within such a diversified approach, if any segment performs poorly due to various market conditions, the overall revenues don’t get hit too hard.
Diverse Revenue and BAC Stock
The bank’s income is divided into two main categories: net interest income (NII) and noninterest income. Let us take a closer look at how each category fared in Q1.
Like other banks, BAC earns income on loans and other interest-earning assets. It pays interest on deposits and other interest-bearing liabilities. We can arrive at the bank’s net interest income by deducting interest paid from the total interest earned.
NII brings in slightly more than 50% of Bank of America’s net revenue. On the call, the bank warned that its 2019 net interest income would be below expectations as management blamed uncontrollable factors, i.e., a slowing U.S. economy and the declining interest rates.
Chief Financial Officer Paul Donofrio said that management expects NII growth in 2019 to be about 3%, assuming the yield curve remains flat and the Federal Reserve doesn’t raise interest rates any further. In other words, investors should not expect that BAC’s net interest margin might improve any further this year.
BAC’s noninterest income is made up of income from several sources, including investment and brokerage services, banking-related service charges, credit card-related fees, trading profit and losses, and mortgage-related activities. Management highlighted a challenging capital markets and investment banking environment that affected the quarterly results.
BAC Stock and Shareholder Value
In the U.S., the bank serves about 66 million consumer and small business clients, giving the bank an attractive deposit base. As of the end of Q1, it has 4,353 retail financial centers and plans to increase that number in the coming quarters. The group’s online and mobile banking operations are also growing fast, adding to increased fees charged for banking activities.
Due to extensive expense-management measures over the past several years, Bank of America’s efficiency ratio has also improved (i.e., gone down) from 60% to 57% over the year. A decrease in the ratio means that the bank incurred lower costs to generate every dollar of income. For banks, the objective is to get the efficiency ratio as close to 50% as possible.
The efficiency ratio is calculated by dividing the BAC’s noninterest expenses by its net revenue. Noninterest expenses may include personnel salaries and other related expenses, marketing costs, and real estate rent, etc. Over the quarter, BAC’s noninterest expense declined over 4%. This respectable overall number (i.e. 57%) by BAC shows how effective management’s cost-cutting initiatives have been.
The group’s trailing price-to-earnings ratio of 11X (versus the industry average of 13x) is likely to catch the attention of value investors. Long-term investors also enjoy a current dividend yield of 2.05%. In June 2018, the group announced a new capital return program that includes a share repurchase transaction for $20 billion. In its Q1 2019 earnings release, the bank said that it bought back $6.3 billion worth of common stock within the quarter.
BAC Stock in the Short Term
The outlook given by Bank of America in April shows that the banking cycle in the U.S. isn’t at its most attractive point. Our economy which has fired on almost all cylinders for a number of years may now be poised to glide onto a slower growth trajectory.
Bank stocks are exposed to economic ebb and flow. Any investor who is considering buying banking stocks should always remember that two main factors affect a bank’s revenue and earnings:
- Interest rates: As interest rates increase, a bank can earn more money from its loan portfolio.
- Economic activity outlook: In a robust economy, more money circulates through the system fuelling a bank’s noninterest income.
In short, if the U.S. economy cools down in the coming months, Bank of America stock is likely to be adversely affected. Despite the potential economic headwinds, it is not quite possible to know if or when we will enter a recession in the coming quarters.
FED’s rate-hike cycle now looks over. Furthermore, one can even argue that we have some ambiguity over further Fed rate decisions. In other words, if there is a sudden interest rate cut by the FED, then BAC earnings from loans could even suffer further. Then there would be more pressure for better performance by its banking activities that bring in noninterest income, such as investment banking and trading operations.
Bank of America also has some non-U.S. exposure, another potential factor that can affect its earnings. The bank’s global operations contribute about 15% of its revenues. This geographical diversification can help decrease some of the reliance on the U.S. economy. However, it can also add to global macro risks the bank may face.
Investors tend to punish companies that do not grow fast enough. To achieve “sustainable and responsible growth,” CEO Brian Moynihan’s strategy is for the revenue to grow at Gross Domestic Product (GDP) plus 1-2 percentage points. If Bank of America misses that growth target during the year, then investors may decide to wait on the sidelines.
So Should You Buy BAC Stock in May?
As a result of the impressive run-up in the stock price in 2019, short-term technical indicators had become somewhat “overbought” until last week. Since May 6, however, BAC stock, like many other stocks in the broader market, has been negatively impacted by the ramping rhetoric of the U.S.-China trade wars.
Although Bank of America stock staged a strong come back on May 10, I believe the volatility and selling in the markets will continue in May.
Therefore, in the coming weeks, I expect BAC stock to decline toward $27-25 level and then trade sideways until the next earnings release in mid-July.
In other words, I would be a buyer of Bank of America stock as it approaches $25, a level where the price is likely to find major support.
If you already own BAC shares, you might want to stay the course and hold your position. That said, if you are worried about short-term profit taking, then within the parameters of your portfolio allocation and risk/return profile, you may consider placing a stop loss at about 3%-5% below the current price point, to protect your profits to date.
If you are an experienced investor in the options market, you may also consider using a covered call strategy with approximately a three-month time horizon. In that case, you may, for example, buy 100 shares of BAC at a limit price of $29.58 and, at the same time, sell an BAC Aug 18 $30 call option, which currently trades at $1.27.
The $30 option offers some downside protection in case of volatility and a decline in BAC stock. This call option would stop trading on Aug. 18, 2019, and expire on Aug. 19. Such a covered call option strategy may allow shareholders to benefit from the stock’s 2.05% dividend yield while avoiding the potential volatility and price drop, at least partially.
I would not advocate bottom-picking in case of near-term price weakness. Yet, I find Bank of America stock to be a buy candidate if the price declines toward $25. By the end of 2020, I’d expect the shares to reach $31-32.
As of this writing, Tezcan Gecgil did not hold a position in any of the aforementioned securities.
