Bank of America: Irrational Pessimism (Rating Downgrade)

Summary:

• Bank of America stock continues to struggle for upward momentum, despite trading at a pessimistic level and having a robust deposit franchise.
• BofA’s deposit-taking capability accounts for approximately 14% of retail deposits and is growing, providing stability and visibility for the bank’s lending business.
• The bank’s debt securities portfolio is a cause for concern, but its significant undervaluation relative to its 10-year average presents an opportunity for patient investors.
• Investors should not wait until the coast is clear before returning to BAC, given its highly attractive risk/reward profile.

Bank of America or BofA (NYSE:BAC) stock has surprised us as it struggles for upward momentum, even though it trades at a highly pessimistic level.

Despite owning a solid deposit franchise and a well-diversified business model, BAC underperformed its financial sector (XLF) peers since its initial attempted recovery, which topped out in April.

Management assured investors in a recent conference in June that its business model is sound and doesn’t see the need to chase deposits, suggesting that deposit outflow is not an imminent concern.

I believe investors have not given sufficient credibility to BofA’s deposit franchise, even though its total deposit base fell 1% QoQ in the March quarter. Bloomberg’s Matt Levine aptly highlighted that the strongest Wall Street banks are the ones that operate “a strong deposit franchise.” These banks don’t have to chase deposits, as they have the ability to “retain primary banking relationships and avoid deposit outflows even as the Federal Reserve tightens monetary policy.”

CEO Brian Moynihan articulated that BofA’s core strengths lie in the bank’s “deposit-taking capability.” He added that BofA accounts for “approximately 14% of retail deposits and growing.”

As such, BofA is not unduly concerned with the behavior of the smaller regional banks as they compete to stem deposit outflow by raising their rates but hurt their funding costs. In contrast, Moynihan reminded investors that “if a bank has no immediate use for the excess cash, it may not be advantageous to chase higher rates.” Therefore, I believe it demonstrates the strength and resilience of BofA’s deposit franchise, creating much-needed stability and visibility for the bank’s lending business. Moreover, BofA’s approach allows the bank to focus on “transactional cash for core operations rather than chasing rates,” creating more stability for their funding costs.

I concur that the bank’s debt securities portfolio is a cause for concern, which I highlighted in a March article. Fellow contributor Julian Lin highlighted the “nearly $114 billion of unrealized losses in their investment portfolio.” As such, I assessed that the market could justify that a discount against its historical valuation average might be needed to account for such risks.

Moreover, the Fed’s revised dot plot suggests that the central bank may not be done with its rate hikes, with another two more in the works if the upcoming data requires a hawkish posture.

While these concerns by the market are valid, I’m not in tune with the argument that BAC needs to trade at such a significant discount to its 10Y average, given the strength of its deposit franchise.

Accordingly, BAC last traded at a forward adjusted P/E of 9x, well below its 10Y average of 11.8x. It’s also well below JPMorgan (JPM) stock’s 10.3x. I concur that the market needs to reflect a discount against JPM’s valuation multiple, given its more robust ROE metrics. However, BAC’s significant undervaluation relative to its 10Y average indicates that the market isn’t confident (yet) that the Fed could move toward a more dovish stance moving ahead.

However, such uncertainty also creates a fantastic opportunity for investors who are patient enough to wait out the recent pessimism and uncertainty as the Fed moves toward a rate cut phase subsequently. While the Fed could hike another one or two more times, we are still much closer to the end than the beginning. Hence, the headwinds on its massive debt securities could also reverse subsequently, attracting more risk-averse investors back into the fold.

However, if you wait till then, the risk/reward profile may no longer be that attractive as BAC reverts toward its 10Y average and possibly more. Makes sense? Moynihan also reminded holders that the bank is confident of better times ahead: “As the economy recovers and enters a growth phase, loan growth is expected to increase.”

Don’t wait till the coast is clear.

Rating: Maintain Buy.

Important note: Investors are reminded to do their own due diligence and not rely on the information provided as financial advice. The rating is also not intended to time a specific entry/exit at the point of writing, unless otherwise specified.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of BAC, XLF either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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