Bank of America Lagging As The Street Prices In Some Odd Developments
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Summary:
- Bank of America has lagged since earnings, with above-average rate sensitivity seen as a risk if the Fed turns more dovish.
- Bank of America has improved its business on many fronts and it would take a sharp drop in the Fed Funds rate (around 250bp-300bp) to justify today’s valuation.
- While Bank of America isn’t my favorite large bank, it’s hard to reconcile the current valuation with the quality and likely trajectory of the bank’s earnings.
tupungato
If you’re going to assume that the market is wrong about a stock, it helps to have a few reasons or explanations in mind. In the case of Bank of America (NYSE:BAC) and the stock’s lagging performance relative to other large banks, it seems that the Street is pricing in a fairly sharp decline in interest rates and/or a pretty significant downward turn in the performance of the business.
While the former is at least possible (the Hall of Fame for interest rate forecasters is pretty much empty), it would seem to me that Bank of America’s profitability would have to regress to 2017/2018 levels (when the Fed Funds rate was about three points lower) for today’s valuation to be fair. Even if rates did decline that much, it would still be giving the bank no credit for market share and efficiency gains over the past five years, nor the growth in non-spread revenue-generating businesses like trading.
With the shares down almost 10% since my last update, I’ve clearly been wrong about these shares in the short term. Bank of America’s asset sensitivity is a risk but one that I think is more than priced into the shares today, and I think this is an interesting relative value among the larger banks.
A Tricky Macro Set Up
To be sure, there are definitely rising macro challenges for banks (and bank stocks). The yield curve is inverted, loan growth is weakening, and credit costs are going to rise from here. At the same time, funding costs are likely to continue accelerating as depositors move their money out of low-cost accounts.
Bank of America remains the most asset-sensitive of the large banks, meaning that this bank’s net interest income would rise more than other banks for a given rise in interest rates. The same is true to a lesser extent for Wells Fargo (WFC) and Regions (RF), while JPMorgan (JPM), Truist (TFC), and U.S. Bancorp (USB) are on the other side of the curve.
Asset sensitivity at this point in the cycle is a risk, but given strong employment numbers and persistent inflation, there could still be an upside to peak Fed Funds rates from here (in other words, the Fed may feel the need to hike rates even more than currently expected). So while it looks as though BAC’s net interest margin has peaked, there are still pathways to upside from here. If rates don’t head higher, though, and if in fact the Fed shifts to a more dovish policy more quickly, there would be greater risk to Bank of America’s spread earnings (asset sensitivity cuts both ways).
Another aspect of this equation is Bank of America’s deposit beta – the rate at which its deposit costs climb in response to higher rates. Thus far, Bank of America’s interest-bearing deposit beta has been quite low relative to many peers (17% versus 44% at Citi, 33% at JPMorgan, 25% at U.S. Bancorp, 19% at PNC, and 9% at Wells Fargo), but the overall deposit beta has been closer to average. Given modestly above-average erosion in non-interest-bearing deposits in the fourth quarter (down about 8%), I do see some modest risk here. That said, a low loan/deposit ratio and ample sources of lending capital do offset that risk.
Self-Help Is Still Relevant
Bank of America has made strides with operating efficiency, leading to its efficiency ratio improving from over 66% in 2021 to less than 63% in Q4’22. While that’s not so exceptional on a relative basis (JPMorgan is in the mid-50%s, and most of its large peers are in the mid-to-high 50%s), it’s worth remembering that the bank has continued to aggressively reinvest in the business (particularly in IT and in building up its trading/banking operations) and could pull back on opex in need be.
I believe these investments will pay dividends over time, though, as they are supporting the growth and competitiveness of the bank’s operations – improving the loan underwriting process (leading to better, faster decisions), improving the customer experience, and building up capabilities in areas like treasury management and payments.
I likewise think that building up the trading business makes sense. Bank of America had a record quarter for trading in the fourth quarter, beating its rivals with 27% year-over-year revenue growth (Citi was next, up 18% yoy). While some of this may be a byproduct of JPMorgan underinvesting to build up its capital ratios, the fact remains that Bank of America has stepped up in what can be a lucrative source of non-spread revenue and profits.
The Outlook
Bank of America is relatively strong in areas that I think will be healthy in 2023, including C&I lending and card lending, but that growth is likely to be tempered by the bank’s focus on maintaining above-average credit quality. All told, I think mid-single-digit loan growth is a reasonable expectation. High-single-digit net interest income growth was a disappointment relative to prior Street expectations, but again there could be some leverage here if rates head even higher.
I’m still expecting long-term core earnings growth in the 4% to 5% range, as I believe Bank of America’s leadership (top market share in numerous markets) will drive meaningful leverage in an industry that rewards scale. The biggest downside I see in terms of earnings power, and one that seems to be factored into the price, is a sharp reset to interest rates. I guess it really depends on whether you believe the prior zero (or near-zero) interest rate policy is the new normal or an aberration.
If 4% to 5% long-term core earnings growth is a viable expectation, Bank of America should trade in the low-$40s. Shorter-term valuation approaches (ROTCE-driven P/TBV and P/E) give me lower targets (averaging out to $39), but not substantially lower.
The Bottom Line
JPMorgan remains my preferred large bank given its overall quality and growth opportunities, but the valuation disconnect I see here at Bank of America remains very interesting to me. Maybe rates will fall more than I expect and/or that Bank of America will struggle more with market share, operating efficiency, and/or credit quality more than I think, but I feel like today’s price prices in a lot of bad news that is unlikely to fully materialize.
Disclosure: I/we have a beneficial long position in the shares of JPM, TFC 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.