Question to the technicians: Take a look at the 10 year chart of Bank of America (BAC). Would you short at this bargain price of $9.71 (as at July 29th 2011)? The price is at its 52-week low, it is short term oversold and the price being hammered in its long term downtrend. No? Great, now we’ve established that there’s substantial downside risk in shorting, let’s turn to the fundamentals.
Bank of America is an unloved stock at this juncture, judging from the recent downtrend. However, it is a favorite among the smart money. Fairholme Fund, Bruce Berkowitz, David Tepper, John Paulson each owns about/more than 5% of the shares outstanding. Along with other institutional funds, this translates to 60% of institutional holdings out of the common stock outstanding/float of 10Bil shares.
But we will be remiss if we did not highlight the net insider buys of 80k shares (or 1.8% of the total insider shares held of 4.46mil shares) for the past 6 months. Insiders may sell for a variety of reasons but there’s only one reason that they buy- the stock is undervalued.
Bank of America is the nation's largest consumer and small-business bank. The bank has offices in 32 states, Washington, D.C., and in more than 30 countries. Along with its complete product offerings for the retail client, B of A also has a sizable middle-market and large corporate lending business, asset-management unit, and investment banking business.
Cursory view of the big picture
Most bank analysts would opine that it is tough to perform bottom up analysis on banks due to the larger influence that macroeconomic factor have on the underlying performance of the business. Banking is a cyclical industry and we will only add it to our portfolio once economy provides them with tailwinds rather than headwinds. This is because at the late upswing of the business cycle, you would want to own interest sensitive stocks such as financials that will outperform others when the rates increase.
Few reasons the current price $9.71 provides a favorable entry point now:
1) BAC is trading at a discount to its tangible book value of low mid-teens $13+ mainly due to the overhang of mortgage losses and lawsuits. Read It’s official: Citigroup (C) is no longer the most troubled big U.S. bank. That honor now goes, hands down, to Bank of America (BAC): http://money.msn.com/top-stocks/post.aspx?post=0587437b-d0a6-4668-a57f-44f8bf0fbd8b
2) Merrill Lynch franchise value will be earnings accretive to Bank of America. “Its investment bank and trading operations, largely inherited with the 2009 acquisition of securities firm Merrill Lynch & Co., accounted for $2.1 billion of profit in the first quarter” (Source: http://online.wsj.com/article/SB10001424052748703648304576265300602161880.html)
3) Bullish inverted hammer at $9.71 had appeared at its 52 week low, which signals to reversal of downtrend, in conjunction with strong psychological support level. We think this is a compelling entry point, provided the investor is with a long term view and willing to ride out the high volatility (beta at 2.45).
Why we like BAC:
These are my interpretation from the thesis of Fairholme Fund: http://www.fairholmefunds.com/pdf/amaii2011.pdf
1) Its tangible book value (real assets of the company if the firm goes out of business) is in the low teens of $13+ which is below its book value (tangible value and goodwill) of $20+
2) Brian Moynihan, CEO and chairman stated in their presentations that they expect to payout all their money with expected blend of one third dividends and the rest in buybacks. The price will then rise in tandem with these shareholder friendly actions
3) Banking is a cyclical industry thus every 5 to 10 years the banks blow up. Thus we opined that with the stringent regulatory reforms in the aftermath of financial crisis, an investor can be more assured that the banks will managed their risk more effectively, providing limited downside risk
4) Bruce Berkowitz from Fairholme Fund asserted that its fund would own more if they could, but was constrained by the 5% ownership due to broker deal elements. It owns about a billion dollar plus position. A bit of background on Bruce if you didn’t already know, that he was selected by Morningstar as the Domestic Stock Manager of the Decade.
We opined that:
5) Increased number of short interest from 108mil prior month to 125mil, but only a measly 1.2% of 10Bil floats as at July 15th 2011. The short sellers aren’t convinced that their upside risk is warranted at this juncture
6) Disregarding the mortgage putback risk (concerns were assuaged by statement “BofA said June 29 it would pay $8.5 billion to resolve mortgage-repurchase claims filed last fall by major institutional investors including BlackRock and Pimco. Under the deal, Bank of New York Mellon (BK), the trustee for the trusts holding residential mortgage-backed securities issued by BofA's Countrywide unit, won't force BofA to repurchase mortgages that failed to meet the bank's underwriting guidelines” from http://finance.fortune.cnn.com/2011/07/11/congressman-takes-aim-at-bofa-deal/, the upside is estimated to be at $20. Its peers, Citigroup and Wells Fargo are trading close to 12x P/E, so when BAC achieves the same level of earnings power, it should be trading at $20 (assuming EPS of $0.01). The upside is therefore 100%. Assuming the timeframe of 3 years with average growth rate of past 10 years of 10%, book value of $20 and discounting it at 12% rate gives a fair value of $20 (per GuruFocus fair value calculator). Therefore BAC seems to trade at relatively high margin of safety of 52%, a consensus of which its peers are trading at 60%+ agrees upon.
7) BAC’s effective risk management with loan to deposit ratio of almost 1x “The large banks are certainly well -capitalized to make loans. Bank of America's(BAC) loan-to-deposit ratio has dropped to 96% as of March 31, from 109% in March 2007” from http://www.thestreet.com/story/11163927/1/banks-want-to-lend-but-no-one-wants-to-borrow.html. We will be worried if BAC levered on its deposits to make unnecessary loans with loose lending credit standards, despite anemic demand for loans
8) Current zero interest rate policy allows BAC to earn attractive spreads as it is backed by large deposit base.
9) The board appears to support CEO and Chairman Mr Moynihan despite some hiccups on his decision making, “On Friday, Bank of America Corp. Chief Executive Brian Moynihan abruptly shook up his management team and accelerated a planned exit of Chief Financial Officer Chuck Noski, who spent less than a year on the job. The move came as the bank announced a 36% drop in first-quarter earnings, reinforcing Bank of America's status as a laggard among major U.S. banks. Mr. Moynihan, who has been on the job for just over a year, also hired a former top Securities and Exchange Commission lawyer, Gary Lynch, who is well regarded on Wall Street, to become the chief of legal, compliance and regulatory relations” (Source: http://online.wsj.com/article/SB10001424052748703648304576265300602161880.html). "All strong leaders have critics, but in a short period of time Brian has aligned the management team and the company around a clear forward-looking strategy that will pay off over time," said Bank of America spokesman James Mahoney. It seems that Moynihan's leadership style is unquestionably tough, unwavering and he made certain that the principal (shareholders) and agent (management) interests are aligned.
BAC faces few significant headwinds:
1) It has earned the reputation as the most troubled big US bank due to overhang of mortgage losses lawsuits inherited from Countrywide Financial (see investment thesis above)
2) If BAC needs to raise more capital to buffer its losses, the downside risk remains. However, “Bank of America Chief Executive Brian Moynihan remained adamant Tuesday the bank has no intention or need to raise capital to meet new global standards. Moynihan went right to the “important” topic in his introductory remarks, saying again, “we don’t need to raise capital” and said its capital, under current standards, was better than expected in the quarter” (from http://blogs.wsj.com/deals/2011/07/19/bank-of-america-ceo-read-my-lips-no-new-capital-raise/). Since there is a comfort that BAC does not foresee itself raising any capital (no dilution), the tangible book value of $13+ thus provides a margin of safety
BAC appears to be the cheapest, among its peers of JP Morgan Chase (JPM), Citigroup (C ) and Wells Fargo (WFC), trading at 50% of its book value (book value $20 estimate), 75% of its tangible book value (tangible book value $13 estimate), with undefined earnings power due to recent reported TTM EPS losses of 0.34.
Obviously all of its relative value metrics of P/E, P/S and P/B are the lowest among BAC’s comparable, outlined below. BAC has large exposure in mortgage due to its acquisition of Countrywide Financial which was the largest mortgage originator. Therefore, the large valuation gap seems justified at this point.
|(Assuming the same growth rates and discount rate)|
|Margin Of Safety:||17%||67%||66%||60%|
1) Once the risk of mortgage putback is over/reduced, institutional investors may pile back on to the stock. It is the uncertainty of legal suits that keep investors at bay.
2) Improving mortgage and employment data against better macroeconomic backdrop. As S&P/Case-Shiller Home Price Indices points out on July 26th 2011, Some More Seasonal Improvement in Home Prices According to the S&P/Case-Shiller Home Price Indices(PDF): “Data through May 2011, released today by S&P Indices for its S&P/Case-Shiller Home Price Indices, the leading measure of U.S. home prices, show a second consecutive month of increase in prices for the 10- and 20-City Composites.” This will speed up BAC’s ability to realize its earnings power in due course.
3) BAC implements a reverse stock split just like its competitor Citigroup to spur the price in the optimal trading price of $20-$80 range. It is interesting to note that BAC has the highest shares outstanding of 10Bil in comparison to JPM (4Bil), C (3Bil) and WFC (5.3Bil).
We conclude that BAC is indeed enticing for the more adventurous investors that don’t mind holding a highly volatile financial stock, which is poised for an uptrend. Once the analysts recalibrate their earnings expectations/views and BAC's management communicates its quarterly earnings and key strategies on Oct 17th 2011 should catalyze the price movement, in the event BAC is stuck in a trading range-bound from now. Slight downside risks may temper investors’ enthusiasm for the least loved financial stock for now, but its tangible book value is in the low teens of $13+ which is below its book value of $20+, attractive margin of safety of 17%, coupled with favorable entry point at $9.71 (utilizing technical analysis), we expect that it is only a matter of time that BAC’s valuation discount to peers narrows.
(Sources of financial data/background: GuruFocus, Morningstar & Yahoo Finance)
This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice.This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities.
Disclosure: We currently do not have any BAC holdings but may initiate it within the next 48 hours.
About the author:Graduated with BA Economics from National University of Singapore. Passed Level 1 of the CFA examination and CAIA Level I Candidate. Long-biased US equities, with strong focus on small to mid-cap stocks (NYSE, NASDAQ, AMEX, OTC & ADR) utilizing fundamental and technical analysis.
Agnostic investor, trader, writer and perpetual student of the market.