Well, it has certainly been an interesting week for the banking industry. The failure of Silicon Valley Bank has sent bank stocks into a tailspin. The regionals and smaller niche lenders have fared the worst, but even the big money center banks like Bank of America (BAC) have been caught up in the maelstrom.
For bank stock investors, there are probably a few salutary lessons to be had from this debacle. One is that banks are far less the masters of their own destiny than many other types of business. Granted, some of these banks may well be deserving of their fate, but it remains the case that a fear-driven deposit run can wipe out even a well run small bank. That is a very good reason to favor the PepsiCos and Coca-Colas of this world. They may stumble, but there is simply no real equivalent of an irrational deposit run that could blow these companies up.
Furthermore, the implicit difference between banks of varying size has also come to the fore. Because there is no inherent difference between a dollar of deposits here or a dollar of deposits there, big banks are in a much better place now than smaller ones. This may or may not result in a discount being applied to smaller names, regardless of how sound they are, although the Fed’s recent actions may negate this.
Again, this isn’t really something that translates over to the world of high quality defensive investing. For instance, Hershey’s enterprise value may be 6 times lower than Coca-Cola’s, but its 40% share of the domestic chocolate market affords it very similar characteristics in terms of earnings stability and quality.
Finally, management is really important at a bank. This is pertinent in light of the mess at First Republic Bank, which by all accounts is actually a decent company that maybe stretched itself a bit too far. The world of defensive investing is much, much more forgiving to the equity investor, where a misstep often means little worse than a few quiet years while profits continue to roll in. See Anheuser-Busch InBev, Mondelez et al as good examples of this.
Back to Bank of America, which is down over 15% in March alone and 4% on the day at time of writing. I believe the recent actions of the Fed render any lingering survival questions moot now, not that they were realistic ones to begin with. There are some suggestions that the scale of unrealized losses in Bank of America’s HTM securities portfolio pose it an existential threat, though I’m not sure I agree. While it’s true this would take a chunk out of tangible equity if they were sold, that “if” is doing some heavy lifting. Bank of America has tens of billions of dollars stashed at the Fed and with other banks, so the prospect of forced selling, thereby crystallizing those losses, to meet some doomsday deposit run scenario seems unlikely to me.
The Fed’s Bank Term Funding Program probably renders this somewhat academic now, as in such a scenario Bank of America could access short-term cash in exchange for collateral if it so needed. Also, as alluded to above, if anything the big banks will emerge as beneficiaries if folks fretting about the safety of smaller players leads them to seek refuge in size. There is an implicit advantage for conservative investors in being “too big to fail”.
Where Bank of America does have a problem is on the earnings side of things. Funding costs may, probably will, go up a fair amount; credit and fee-based product demand may slow; asset quality may go down, and so on. All of those things mean lower profits for Bank of America stockholders. As a result, the stock has lost over 30% of its value in the past 12 months.
Assuming you can satisfy yourself as to the “will this thing survive?” question, my somewhat provocative take on this is that investors should embrace cycle-driven share price declines. I say that because over the past five years Bank of America’s net income has ranged from around $18 billion to $32 billion. Relative to tangible book value, earnings have landed between 9.5% and 15.7% in any given year. Such variation is just the way life is when your business results are dictated in large part by macroeconomic factors. The market has driven down Bank of America’s value because forward expectations are now shifting toward the lower-end of, or even below, those ranges. In one sense, Bank of America stock isn’t any cheaper because its lower share price now matches a lower earnings outlook, but under estimates of mid-cycle earnings Bank of America stock is now a whole lot cheaper than it was even two weeks ago.
My screen shows that analysts expect Bank of America to earn roughly $27.5 billion in net income this year and $28.5 billion next year. The bank has a current market capitalization of $220 billion, meaning its P/E ratio is below 8 on those earnings figures. Relative to tangible book value of around $180 billion, Bank of America trades at a multiple of 1.25. Earnings could fall to their 2020 COVID levels and still leave the stock on a P/E of 12, backed by a 10% return on tangible book. That looks like a very good deal provided your horizon stretches beyond the vicinity of the next one or two years.
There are a few other things worth considering. Firstly, Bank of America’s raw net income figure masks the degree of stock buybacks it has conducted on behalf of shareholders, which amounts to around $98 billion over the past six years. You can add a further $40 billion in cumulative dividend cash to that for good measure. When it made $18 billion in annual net income in 2017, it had to be spread over 10.7 billion shares. Now, if Bank of America ever makes $18 billion in a future year, probably in a recession, it would only have to be spread over 8 billion shares based on its current share count. There has been tangible progress on earnings growth when comparing apples to apples.
Secondly, any capital returns conducted from this point on come with extra juice, because the bank can purchase its shares at a 12.5% earnings yield now rather than a 7% earnings yield one year ago. Investors can do the same with their cash dividends. That is going to show up big time for shareholders in a few years. The only risk is that things get so bad that the bank is forced to retain capital by the Fed.
Finally, Bank of America posses an inbuilt volatility deflator simply because it runs a diverse set of franchises. When profits from the bread-and-butter lending operations come under pressure, they are often bailed out to a degree by earnings in the investment bank. This helps support overall income in a not-dissimilar way to how Exxon Mobil can lean on refining profits when oil prices tank.
Bank of America stock is in an interesting place right now. The market has already decided to discount a large amount of its earnings power, which may or may not prove reasonable in the near term. For cyclical companies, these are counter-intuitively good times to buy, because in a bad case you get a fair price until the cycle turns again while leaving near-term upside should the world not end.
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