Our investment premise for Bank of New York Mellon (NYSE:BK) is that it is a strong book value compounder that is substantially "under-earning" its profitability potential. The Company has undertaken significant cost savings initiatives, which combined with market-leading digital platform investments, should drive future growth and market share gains. The Company's balance sheet is strong with significant excess capital enabling a sizable return of capital to shareholders through both dividend and share buybacks. Lastly, with activist interest still high, any loss of momentum could lead to renewed calls for a break-up of the company to accelerate closure of the discount to NAV.
BK's book value and tangible book value growth both inflected positively in 2016 over its three-year trailing averages, over and above strong buyback and dividend activity, and we see this growth as set to accelerate with stronger earnings. Earnings Per Share (EPS) growth finally reaccelerated in 2015 and 2016, to $2.85 and $3.17, respectively, after languishing in the low-$2 per share range from 2011 to 2014. Management, spurred by activist pressure and new board members in 2014, has accelerated its cost reduction efforts and has committed to positive operating leverage regardless of the revenue growth environment. The results of this focus are clearly seen in 4Q 2016 earnings where non-interest expenses fell 2.1% while revenues grew 1.7%, generating 351 basis points of positive operating leverage. This cost-cutting focus is a key tenant of our investment case and an underlying pillar of why we believe BK shares can outperform regardless of the broader market environment. Further, while this cost reduction focus was started in 2014 when falling interest rates and meager corporate activity were suppressing revenues, we think the current tailwinds of higher interest rates and better corporate activity should also accelerate revenue growth, providing even stronger earnings leverage over the next few years that could push 2018 EPS to the $4.00 per share level.
More compelling to us is the fact that BK's cost reduction efforts are not just aimed at rote headcount reductions. BK has been aggressively investing in its new Nexen platform, an open-source, cloud-based technology platform aimed at improving client efficiency and flexibility. This platform will both help to drive revenue growth and likely share gains through its forward looking client-responsive features, and also dramatically lower costs as it is replacing legacy server based systems and consolidating multiple client access points to just one.
BK's strong balance sheet metrics continued to improve in 2016 (Common Equity Tier 1 ratio of 12.3%, up from 11.5% year over year), over and above its substantial return of value to shareholders in dividends ($778 million) and share buybacks ($2.4 billion). Management has committed to continued strong dividends (90%400% payout ratio) and share buybacks for 2017. The buybacks are having a dramatic effect on the company, as the fully diluted share count declined 3.6% in 2016 and fell 12.3% over the last 5-years.
Despite the strong credit and earnings metrics at BK, its shares underperformed the S&P 500 post-election, up 7.6% through March 31, 2017 vs. 10.4% for the S&P 500. Moreover, BK is currently trading towards the lower end of its price-to-book and price-to-earnings ranges for the last 10 years. While we continue to take a 3-5 year view on BK, even a near term price target for 2018 at a 15x price earnings ratio on $4.00 EPS would yield a $60 stock price, which is more than 26% above current levels. Clearly we see significant value in Bank of New York Mellon, regardless of overall market levels currently.
From Third Avenue Management (Trades, Portfolio)'s Value Fund first quarter 2017 commentary.
