I’ve recommended Bank of America (NYSE:BAC) stock as far back as the 2016 U.S. presidential election but for the last 18 months, it’s been a bad call. Bank of America stock still sits below where it traded at the beginning of 2018.
The absence of gains seems frustrating and almost unexplainable. BofA doesn’t have the obvious problems of rival Wells Fargo (NYSE:WFC). Nor is it undergoing a multi-year turnaround, as is Citigroup (NYSE:C). This is a solid banking franchise, one that rivals JPMorgan Chase (NYSE:JPM) for the top spot among big U.S. banks.
Meanwhile, Bank of America stock has been cheap, and is now even cheaper. Yet with the BAC stock price back above $30, the shares still trade at less than 11x this year’s earnings estimates. Price-to-book is 1.2x — and this is a stock that traded at 3x+ before the financial crisis. Given a strong economy, those multiples seem far too low.
But as BAC has stalled out over the past year and half, I’ve become incrementally less positive on the bull case. And in this environment, in particular, there’s an obvious headwind facing the stock. Yes, BofA is cheap and long-term investors probably can’t go wrong. Still, I wouldn’t be surprised to see the sideways trading continuing for some time to come.
Core Problem with BAC Stock
From a (very) broad standpoint, Bank of America needs two conditions to perform well. It needs a strong U.S. economy, so that borrowers can repay its loans. And it would prefer higher interest rates, which create a solid spread between the interest paid to depositors and what it charges borrowers.
Right now, BofA is getting one of the two. The economy is strong, and the bank continues to perform spectacularly well in terms of credit quality. Net charge-offs in Q2 were just 0.38% of loans outstanding. The provision for credit losses did increase $30 million year-over-year, but was down from Q1 levels.
Both figures are near historic lows as a percentage of BofA’s outstanding loans. That’s the good news.
The bad news is that the bank’s lending spread — or net interest margin (NIM) — continues to be relatively low. The company trimmed its outlook for NIM growth to 2%, according to the Q1 conference call. And if the Federal Reserve cuts rates, as is expected, that growth could dip to 1% or less for the full year.
A move of one or two points in net interest margin growth doesn’t seem like much. But it is.
The NIM Growth Problem
The first issue is that net interest margin is basically how the consumer banking business — still BofA’s largest contributor — makes money. Cut that top-line growth, and it’s very difficult, even in a roaring economy, for BofA to consistently grow margins.
So far, Bank of America has managed to control costs to an impressive degree. It has generated operating leverage — revenue growth that outpaces expense growth — for 18 straight quarters. That can’t last forever, though. The company is boosting wages for tellers and other employees. Costs can’t be cut endlessly. At a certain point, BofA’s earnings are going to decline without accelerated revenue growth.
And if that growth doesn’t come from net interest margin, it’s hard to see where it does come from. Trading revenue in both equities and fixed-income continues to decline — and that’s not just a BofA problem. Traditional investment banks like Goldman Sachs (NYSE:GS) are seeing similar pressure.
Even if the economy stays strong, as long as rates stay low BofA’s earnings growth is going to stall out at some point. In that context, the 10x+ multiple to 2019 earnings seems reasonable. But even that doesn’t account for the cyclical risk to Bank of America stock.
At some point, the economy is going to turn. Charge-offs and loan provisions will rise and Bank of America’s earnings likely will decline when that happens.
Why Bank of America Stock Has a Lid On It
Trying to time that cyclical shift is something close to a fool’s errand, to be sure. And, again, I’m still broadly bullish on BofA. Owning this business as a modest premium to its net assets seems like a good deal — and maybe even a “set it and forget it” kind of play.
But in the coming years, expecting a lot from BAC stock seems overly optimistic. The Fed seems intent on cutting rates, which will further pressure the net interest margin. Should the economy stay strong, it’s difficult to see why those rates rise any time soon. If it weakens, BAC stock takes a hit. (Indeed, an investor need only look at the Q4 dip in BofA stock, amid cyclical fears, to see how quick and violent the sell-off could be.)
Bank of America, simply put, is years away from getting back to an ideal environment. At a time when so many other stocks are in a better spot, it’s that much more difficult to make the case that Bank of America stock is compelling, as cheap as it looks.
As of this writing, Vince Martin has no positions in any securities mentioned.