At $5, Bank of America (BAC, Financial) was super cheap. Even now, on a relative price to earnings basis, the stock looks like a bargain. However, if I could truly determine that the company had the potential to reach the $4 per share in EPS it had a decade ago, then I’d be much more definitive about holding on.
One factor is the volatility around Fed movements. While the banks are going to make money one way or another, the country as a whole cannot afford higher rates without a total restructuring, and we don’t want to end up like Puerto Rico.
On Jan. 19, Bank of America reported fourth-quarter net income of $3.3 billion, which was up 9% year over year to 28 cents per share, up from 25 cents. On the whole, things are going in the right direction. Bank of America now pays a 5 cent dividend per quarter, and I’m confident that this will also expand over time. “Low inflation” seems to be the biggest risk for bank growth, as interest rates are likely to remain under 1% for some time. Bank of America's competitive advantages stem from its massive deposit and consumer lending franchise, as well as the brokers and wealth managers at Merrill Lynch. Frankly, most of the company's problems are behind it and the franchise itself is incredibly valuable.
There’s a lot to be excited about with Bank of America:
- Consumer loans were up $12 billion.
- Deposits were up $48 billion year over year.
- Brokerage assets were up 8%.
- Total mortgage production increased by 13%.
- Total U.S. credit card spending improved by 5%.
- BAC Investment Management has nearly $2.5 trillion.
- The company was number three in Global Investment Banking Fees.
Two questions come to mind when evaluating investments:
The first question is: Will the value of this asset produce better than market rates of interest over the next five and 10 years? The second question is, will the return produced be better than other assets that could be bought with the same money? Both of these questions presuppose an err to the side of caution as a value investor, as I seek to earn 15% a year on my money.
1. Will Bank of America outpace the growth of the S&P 500?
I think that the return on the S&P will move down to around 8% annually (at best) over the next 10 years. That would mean Bank of America needs to be above $20 by 2021 and above $30 by 2025. Management has estimated that a 100-basis-point rise in interest rates would add $4.5 billion to net interest income in the following year. However, the Federal Reserve will be very hard pressed to make any increases, incremental or instantaneous, in the next few years. Even if the company did at $4.5 billion in net income, that would only move the EPS to about $1.90. I would like to see it in the $3 to $4 range.
2. Can I invest elsewhere with better results?
The answer here is virtually 100% yes. Seeing as I am not trying to earn 15% on $1 billion, screening for stocks right now yields a lot of potential buying opportunities. In fact, in the banking industry alone, the big competitors to Bank of America all look like bargains. Another factor comes into play: size. I almost have to wonder why any small investor would be so inclined to buy into a $139 billion company, especially when there are more than 100 stocks with low P/E ratios (under 6x) generating 12% a year on equity, 86 with price to book (P/B) ratios under 1. And that’s just a quick 2 minute search. An investor should be able to find at least one company that can produce 50% year over year ROI in this market, right? Ah, the “bird in the hand” scenario comes to mind.
Bank of America, trading at less than book value with room to grow, is worth holding unless I can truly pinpoint a better investment. As I tend to only hold a few stocks at a time and look to double my money over a five and 10-year period, for Bank of America to generate the results I want, the stock would need to trade around $28 by the end of 2020. The only way that’s happening (in my estimates) is through multiple expansion and continued earnings growth.
The one outlier is Berkshire Hathaway’s (BRK.A, Financial) (BRK.B, Financial) $5 billion capital infusion came with 700 million warrants that could be converted to common stock at a price of $7.14 a share at any time over the next decade. Exercising the warrants would make Berkshire Bank of America’s largest shareholder, and it would also make it hard to unwind the position. That could go either way.
