- Bank Of America customers earn very little from majority of deposit accounts at the bank, partially due to the high switching costs. This is definitely a competitive advantage the bank enjoys.
- The Bank Of America stock is cheap and has plenty of capital to put to use for buybacks or a bigger dividend.
- Long term rates are still falling. Until they rise meaningfully, bank stocks will be rangebound.
If there is one industry that is really forward looking on Wall-Street, it has to be the financial sector. Just look at the performance in the last calendar year, especially that of Bank of America (NYSE:BAC). There was more movement in this stock as a result of sentiment (whether the Fed would move on rates - FOMC meetings) than its earnings results. The stock finished down over 6% despite beating EPS in its second and third quarter. Bank of America Q4 2015 earnings, which will be announced on the 19th of January before the market opens, are estimated to come in at $0.27. Predicted earnings are substantially less than Q3 as business is always slower for this bank in Q4. The spike in volatility (VIX) which is up by 48% since the start of the year hasn't been friendly to the financial sector in 2016. Bank Of America is down over 11% and the financial ETF Financial Select Sector SPDR ETF (NYSEMKT:XLF) is down almost 9%. The S&P 500 as I write is trading at sub 1,900 levels and if it keeps on drifting lower (with elevated volatility), the likelihood of a second interest rate rise in March to me looks slim. However, this stock looks attractive for investors who have confidence in the US economy going forward. If the economy can withstand a tightening cycle by the Fed, Bank Of America's valuation and balance sheet make it one of the stand-out picks in this sector.
Firstly, its balance sheet definitely makes it a leveraged play on rising interest rates and US economic growth. Why? Well, just look at its growing deposit base which came in at $1.162 billion in its latest set of earnings. Now the advantage the bank has here is that 37% of this total (see below) are non interest bearing deposits which means that $429 million carries no interest rate risk to the bank. In effect, whatever interest rates do in the near term, Bank of America will not be more out of pocket (by paying out more interest) from holding this capital which is a huge advantage going forward. Furthermore, on the interest side, the vast majority of this capital is in on-deposit accounts meaning that the interest paid is more or less the same as the Fed fund rate. What does this mean to an investor in this space. Well as long as BAC can continue to pay peanuts on a relative basis on its liabilities (deposits), its net interest income should rise sharply when interest rates rise as its loan book (assets) should become far more profitable and which, incidentally, are growing strongly at present.
Source: Bank Of America Earnings presentation
Bank Of America Stock Trades At Cheap Valuations
The bank's dividend pay-out ratio is only 15% and its debt to equity ratio at a current 1.02 is at its lowest in a decade. If profits continue to flow at the bank, many believe the dividend will get hiked in the near term. This will definitely bring in value investors especially when you take note of the bank's forward price to earnings ratio which has dropped sharply to 8.6 due to recent volatility. Furthermore, the stock is still trading 30% off its present book value which makes the bank one of the cheapest in this sector. Even if the bank prefers to use its excess cash for increasing buybacks (could reach $5 billion in 2016), the stock will still be supported either through internal buying or more value investors coming into the equation.
Nevertheless, its the recent hike in earnings which has re-captivated investor's attention on this stock. The bank has a trailing twelve months EPS of $1.33 which is almost a full $1 in EPS higher than fiscal 2014. If the bank can report an earnings beat next week, it wont be far away from $1.4 in earnings per share for the full year. The market believes momentum will continue as EPS is predicted to get to $1.55 in 2016. However, elevated volatility in markets this year has meant that US bonds have rallied meaningfully. The 20 year treasury bond, for example, iShares 20+ Year Treasury Bond (NYSEMKT:TLT) is up almost 4% which means the 10 year is quickly approaching yields of 2%. Bank Of America is going to find it very difficult to keep earnings growth going if long term interest rates are falling. Bond buying in recent years has been the flight to safety trade. If volatility keeps up and bond buying becomes even more intensified, this could be the perfect excuse for the Fed not to continue with its tightening process.
To sum up, Bank Of America has everything in place to be the US bank that outperforms over the next few years. It has significantly cut expenses, has a strong balance sheet to ensure either strong dividend hikes or buybacks continuing in the future and the stock trades at a low valuation compared to its peers. The one major outlier is the US economy. This bank needs solid loan demand for its deposits, a vibrant housing market and low unemployment to ensure charge off's remain at a minimum going forward. If you are bullish on the US economy going forward, this bank stock will easily return to its present book value per share.