Whatever people may think about bank stocks, Bank of America (NYSE:BAC) has enjoyed great profitability in the past several years. As a result, it has begun returning large amounts of capital to shareholders.
Investors have seen dividend increases, but also plenty of share repurchases of Bank of America stock. Recently a very insightful article in Seeking Alpha argued that these capital returns are very likely to continue for the foreseeable future.
Once a year, the Federal Reserve grants requests from 18 of the largest and major U.S. banks to increase their dividends and buyback shares. This past summer the Fed released the analysis of its Comprehensive Capital Analysis and Review (CCAR) examinations. These examinations are required under the Dodd-Frank Act.
If a bank passes, it can then go on to complete the dividend and buyback plans it requested.
This past summer, Bank of America was perceived as the biggest winner, as the Fed allowed it to pay out $37 billion in dividends and buybacks.
Higher Deposits Lead to Lower Risk Asset Lending
The crux of the recent Seeking Alpha article by Regents Research is that Bank of America grew profits by 18% and its earning assets by 11% over the last three years. It did this through huge low-cost deposit growth and a high risk-adjusted net income spread. This allowed BAC to reduce its regulatory capital by 6% over the same period.
In other words, since its deposits carry low or no interest to BAC, it has become more picky about to whom the bank lends. BAC has gotten out of HELOC loans and lowered its exposure to residential mortgages.
In fact, it is now trying to concentrate its lending focus on just the best corporations. It looks for the lowest probability of default borrowers. The bottom line is that this has increased its risk-adjusted net income spread.
The Bank of America Stock Buyback Plan
Bank of America passed the CCAR exams with a Tier 1 common capital ratio of 9.7%. This is well above the required minimum of 4.5%. As a result, the Fed approved BAC’s plan to increase its dividend by 18%. That will cost $6.1 billion over the next year.
In addition, the Fed OKed a massive plan to buyback $30.9 billion of Bank of America stock over the next year. In total, this $37 billion return of capital plan represents over 12% of Bank of Amerca’s present stock market value of $301 billion.
Regents Research argues in their article on Bank of America that it has over $30 billion in excess capital even after these buybacks. In addition, BAC will likely payout 100% of profits to shareholders over the next few years.
What Should Investors Do?
This is an impressive outlook for Bank of America stock. However, I feel that if a recession occurs, or even a growth slowdown, all bets are off.
For example, this summer there was a short scare that the yield curve had become “inverted” or negative. That means that short-term rates were slightly higher than longer-term rates. To some, this signaled that an economic slowdown was on the horizon. This turned out to be not an issue as the yield curve merely flattened and later became positively oriented.
In addition, if inflation becomes an issue, that could complicate things for the bank. Spreads would narrow as its costs rose faster than existing loan interest income.
I would argue that although the continuing buybacks are very impressive at Bank of America, the investor should be on the lookout for a tendency for banks to overdo it.
Buy BAC Stock on Pullbacks
One way to avoid an issue is to buy bank stocks during economic scares like the one this summer.
For example in late March, early June and mid-August you could have bought Bank of America stock in the low-to-mid $27 range. This was 18% below today’s price.
So be on the lookout to pick up Bank of America with a certain margin of safety. After all, that is what it is going to do itself, as it repurchases its own stock.
As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the Total Yield Value Guide which you can review here. The Guide focuses on high total yield value stocks. Subscribers a two-week free trial.
