- Bank of America has a chance to generate $40B of pretax, pre-provision net revenue in 2023 if a few things bounce its way.
- The bank is valued at about 9.4x forward earnings, which is way too cheap given its low-risk business profile and consistent earnings quality.
- Bank of America’s stock dropped 24% last year despite strong business performance, and is poised for a rebound as credit outperforms the draconian assumptions implied in the price.
As we enter into a new year, I think it is finally time to reexamine how we look at banks and their valuations. In the last 13 years, banks have dealt with increased regulation, higher capital requirements, and a historically low interest rate environment, which pressured net interest income. Despite these headwinds, the big 6 banks have nearly generated $1 trillion in net income over the last decade. Their profit production is only matched by the big Tech behemoths such as Apple (AAPL) and Microsoft (MSFT), but still the banks’ trade at paltry valuations as though the next recession will cripple them like 2008 did, while other sectors like utilities and staples trade as though they are growth industries. This disconnect between reality and perception has created an enormous investment opportunity to earn generous dividends and robust stock appreciation through U.S. bank equities. To start 2023, I’ll profile Bank of America (NYSE:BAC), which I believe offers an extremely attractive risk/reward opportunity over the next twenty-four months.
Bank of America is a conservatively run and well-managed bank, which is one of the biggest beneficiaries of higher interest rates. BAC lends to people and businesses with good credit profiles and earnings prospects, keeping its risk of major losses in a recession manageable. The bank has one of the most attractive deposit bases in the industry, with relatively high proportions of deposits that earn very little in interest. Many of BAC’s customers have been so for many years or decades, and rely on the bank as their primary financial institution to pay bills, payroll, utilize ATMs, etc. While other banks such as ALLY or SOFI are more reactive in raising deposit rates, banks like Bank of America can react a little more slowly as many of their customers are just not as rate sensitive. I personally use Wells Fargo as my primary bank and have for decades, and while I’ve been tempted many times to switch it all to another bank like ALLY that will pay me a higher rate on my deposits, the reality is that I have so much tied to my primary bank personally and for business, that it just hasn’t been worth the trouble to do so.
Another thing that sets Bank of America apart from its peers is its Merrill Lynch Wealth Management business. This crown jewel operation earns recurring fee revenues that tend to grow organically and also through market appreciation. Wealth Management earns a return on equity in the high 20% range, while tying up comparatively little capital. It also deepens the connection between Bank of America and its customers, leading to cross-selling opportunities and customer retention. As a financial advisor myself, I’m quite envious of the advisors that can sit in a branch and be introduced to countless clients that are there transacting their everyday banking needs.
The first three quarters of 2022 were very fruitful for Bank of America, as pre-provision net revenue (PPNR) was up 17% YTD. This has come despite a very weak investment banking environment as higher rates and volatility have stifled deal flow. Much of this growth has come from higher interest rates leading to dramatic improvement in net interest income. Bank of America is getting close to earning roughly $40B pretax, pre-provision per annum, generating $9.2B in Q3 2022. This highlights the underlying earnings power of the company to be able to deal with any potential pressures that come around. Provision costs are slowly normalizing towards where they were pre-pandemic and the company will continue to build reserves, as opposed to releasing them as they did a year ago, but credit is still doing quite a bit better than 2019, which was not a bad year for credit whatsoever. BAC’s commercial credit exposure is extremely safe with 92% being investment grade or equivalent rate. The reality is that it would take the mother of all recessions to actually cause a bank like Bank of America to actually lose money in a given year, as the PPNR is so large, and the existing CECL-driven reserves are already so conservative.
In a recent financial services conference, CEO Brian Moynihan discussed that current reserves are based on an unemployment rate by year-end 2023 of between 5-5.5%. Currently the unemployment rate is around 3.7%, so Bank of America is able to withstand significant economic degradation before having to substantially increase its loss reserves. Most of the quarterly reserves are simply replacing charge-offs or due to loan growth. CECL accounting frontloads loan losses, as the banks are required to reserve for future expected loan losses right up front. This creates an interesting paradox in that when creating these loss reserve models, banks must factor in stressed recessionary scenarios, but also plan for an eventual recovery. In today’s regulatory environment with annual stress tests and constant scrutiny, banks tend to error on the conservative side in creating these loss reserves. As of the 3rd quarter of 2022, BAC’s 30+ days past due delinquency rate was 1.38%, down from 2.04% in September of 2019. All the key credit metrics are still significantly better than pre-pandemic and the ultimate driver of credit losses will be unemployment. There just aren’t enough new unemployment claims thankfully to create a major credit issue at this point. Obviously, the Fed is trying to slow economic growth and I do think a recession is very likely, but I don’t think it will be anything like 2008, especially for the big banks.
Bank of America has been generating a return on tangible common shareholders’ equity in excess of 15%, which is excellent. I’d view that to be pretty close to normalized returns across the cycle. Bank of America has a wide variety of businesses that can be counter-cyclical to one another, which can help offset weakness in times of business stress. For example, the trading businesses tend to do well in periods of extreme volatility, while volatility and higher rates can pressure deal flows in the investment banking business, as we saw in 2022. Clearly, higher interest rates are a game changer for BAC’s net interest income, and while we might be done with the most aggressive part of the rate-hiking cycle, it is tough to see rates crashing down to the levels we’ve averaged over the last decade, which should be a major plus for BAC. In 2023, BAC will have the full benefit of the rate hikes we saw in 2022, and while deposit costs will likely creep up a bit, that is far outweighed by the increase in yields on the asset side of the balance sheet.
BAC ended Q3 with a standardized CET 1 ratio of 11%, giving the company a large cushion from its regulatory minimum. Book value per share was $29.26 and TBVPS was $21.26. Total average loans and leases are up about 13% YoY, while deposits are up 1% YoY. 2022 was a good year for Bank of America, as consumer spending was strong, higher interest rates flowed through net interest income, and credit quality was solid. These positives didn’t stop the stock from declining by 24% over the last year though. At a recent price of $33.12, BAC trades at just 9.4x forward earnings and pays a 2.66% dividend yield. A 10% earnings yield for a business that can grow earnings at a faster rate than GDP, and which is likely to remain solidly profitable even if the economy dips into a reasonably strong recession is just too cheap. It is far past time for market analysts to realize that the banking industry is night and day safer than it was prior to the Financial Crisis. Yes, the swashbuckling days allowed the potential for higher peak ROTCE’s, but the lower risk profile is not being given its due credit. I think there is merit to looking at banks more like regulated utilities, which can trade at double the valuation of the big banks. I believe BAC should trade at about 13x my 2023 earnings estimate of roughly $3.50 per share, which would put the stock at around $45 per share. That is not a heroic assumption as the stock’s 52-week high was over $50. Long-term investors should take advantage of the recent weakness in the stock price and buy BAC, regardless of if we are going into a recession. At some point as we saw with energy in 2022, investors will come to appreciate the quality and earnings power of the big banks, and BAC particularly.
Disclosure: I/we have a beneficial long position in the shares of BAC 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.