Bank of America (BAC) is an easy target.
It has been in the regulatory doghouse for a while, especially after failing the Fed's stress test last year. Questions have arisen around CEO Brian Moynihan's credibility. Revenues have remained stagnant. Concerns around its efficiency, as well as energy exposure, have been at the top of many investors' minds. All these issues, combined with low expectations for any rate hikes in 2016 and global recessionary conditions, have caused shares to underperform the broader market drastically, with shares down more than 22% since the start of this year alone.
Let's first address concerns around a global recession. It is true that the International Monetary Fund recently cut its global growth forecast, with several large economies (Brazil and Russia in particular) facing prolonged recessionary conditions, Japan barely escaping yet another one, China decelerating and the eurozone stuck in a persistently stagnant growth phase (or lack thereof), despite monetary easing. This certainly has a spillover effect on the U.S. economy, but more for U.S. multinationals (export risk) than for corporations with their business operations concentrated in the U.S.
I appreciate Bank of America's U.S.-focused exposure (roughly 95% of deposits) for several reasons. There's the deteriorating macro across Asia-Pacific (China being most concerning) and a recent market collapse among European banks, with more than $1.1 trillion USD worth of bad loans still lingering on European banks' books from the last crisis, according to the European Banking Authority. Finally, don't forget the structural collapse in Latin America's largest economy (Brazil) as the commodity-exporting nation teeters on the edge of solvency.
Therefore, while BofA does have some international exposure related to its investment banking /global markets businesses, it is de minimis compared to its bulge bracket peers (with Citigroup (C) being the most exposed). So, if there is in fact a looming global recession, Bank of America is not the bank to pick on.
So what about a U.S. recession? BAC shares are trading (in terms of price to tangible book value, or TBV) below recessionary levels last seen during the recessions in the early 1990s and early 2000s. Its 25% discount to 2016 year-end TBV estimates of $17 (which is derived using relatively conservative assumptions) is historically significant and represents a substantial discount to the stock's valuation during the two aforementioned recessions (in which its price-to-TBV hovered just below 1x at worst).
In fact, the biggest BofA bear of all, CLSA research analyst Mike Mayo, recently upgraded shares to an outright Buy from Sell after he performed stress tests on the bank's model under recessionary assumptions. He discovered that the bank could manage to grow its TBV this year even if faced with a domestic recession and extreme incremental selloff in oil prices. This growth is possible because BofA boasts a strengthened balance sheet, higher capital ratios and improved funding.
Bank of America has built a nice capital cushion that better prepares it for recessionary conditions, as the quality of its books have improved to the point where it can more easily absorb practically any macro, commodity or rate headwind thrown its way. Its equity as a percentage of assets has risen 34% since second quarter 2007, while its Tier 1 common equity ratio has increased 81% over the same period. Next, the bank has experienced a funding transformation, as its loan to deposit ratio declined from 108% in 2Q 2007 to 75% currently; meanwhile, its core deposits as a percentage of liabilities have jumped to 56% from 36% over the same period.
When it comes to risks around its energy book, energy loans represent roughly 2% of total loans, with loans classified as "higher risk," i.e., those issued to producers more directly tied to the swing in prices, representing 39% of the energy book (or less than 0.8% of total loans). The bank has set aside 6% reserves on this portion, and while a dramatic incremental decline in oil prices (below $25 a barrel) would force it to write off more than its provision, this would not dramatically upset the market, which has all but traded the stock as an oil derivative since its disclosure. In fact, the percentage of energy loans considered high risk at BofA (39%) is the lowest across its large-cap banking peer group, with Citi at 51% of its energy book, JPMorgan Chase (JPM) at 83%, and Wells Fargo (WFC), another Action Alerts PLUS holding, at 75%.
While BofA's top line has faltered given stagnant investment banking revenues and relatively muted loan growth, this is an issue shared across the broader investment banking landscape and not isolated to BAC. That is not to claim BofA's revenue trajectory is strong -- it isn't -- but it is not alone in its struggle to grow the top line amid weak capital market conditions, and it does not depend on some inflection in revenue growth for its valuation gap to narrow.
We hope BofA's top line picks up, but such an acceleration is not required for this story to work. For starters, it has managed its loan book well, with 2015 non-performing loans (NPLs) declining 4% in the second quarter, 9% in the third quarter and 4% in the fourth quarter on an annualized basis. This compares to declines of 1%, 3%, and 3% at JPMorgan and 1%, 7% and 1% at Wells Fargo in the same periods.
Read Roger Arnold's bear case against Bank of America here.
More interesting, its commercial and industrial (C&I) NPLs -- an area that has been highly criticized -- grew only 3% in 4Q 2015 vs. a 12% average year-over-year increase across the large-cap banking peer group. In fact, BofA's C&I NPLs as a percent of total NPLs (35%) are among the lowest in the industry, better than Wells Fargo and SunTrust (STI).
Finally, as alluded to before, the shares are stupid cheap to put it simply. Under very conservative assumptions, I estimate that the bank's tangible book value will end the year at $17 (implying a discount based on its current share price). In fact, I view the 25% discount to 2016 estimated TBV per share (and about 18% discount to its Q4 2015 reported TBV per share of $15.62, which represented 6% sequential growth) as an opportunity in and of itself. Since the bank is positioned to massively accelerate its capital returns starting this year (expected to double both buybacks and dividend payments this year and triple buybacks between now and the end of 2017), each dollar invested in shares is immediately accretive to the bank's tangible book value.
From a higher level, comparing Bank of America to Wells Fargo or JPMorgan (which many bears have done), lacks a fundamental understanding of the Bank of America story. Wells, for instance, is undoubtedly a "better bank" (a qualification that stands true against its entire peer group) that has been well known for quite a long time. Wells has an immaculate record of consistency, efficiency and stability, which is why it trades at a major premium to the group.
What makes Bank of America intriguing (beyond its 25% discount to TBV) is that it's the only large-cap bank left that's in the early innings of its growth story. Bank of America's tainted past forced it to rethink its business model, placing it on a road to redemption over the past nine months, which has been overlooked by investors who feel betrayed by the firm's prior missteps. Brian Moynihan has quietly, yet powerfully, transformed the business. The step change in the bank's relationship with regulators -- from class clown to trusted partner -- was made evident when the Fed approved its resubmitted capital plans in December. That effectively freed the bank from suffocating capital requirements and provided it with the flexibility to lower risk-weighted assets, improve its capital ratios and ultimately shift its much-improved balance sheet from a constraint to an accretive mechanism of shareholder returns.
Bank of America may be a "catch-up" story, but it has cleared the most important milestone, putting it on a path that its favored cohorts have already traveled and benefited from. While the timing of the Fed's incremental rate hikes is unclear, the story does not hinge on the Fed or on a top-line acceleration. Rather it hinges on further efficiencies, stronger capital ratios and accelerating capital deployment, all of which should serve to bridge the gap between the "recessionary" valuation it currently trades at and the improvements it has already made, and will continue to make, in the months, quarters and years ahead.