On October 6, 2008, I recommended readers buy shares of Bank of America Corp. (NYSE: BAC).
Bank of America at the time had just agreed to acquire Merrill Lynch and Co. The strategy I recommended called for taking a prudent position in the bank by buying increasing amounts of shares on any market pullbacks.
The strategy appeared to go as planned at the very beginning as the shares dropped in value as predicted, improving the average buying price. But Bank of America subsequently revealed large amounts of troubled assets that had not been evident in prior releases. The company's president and chairman lost his job as a result, and the stock continued to drop. Today, after a very strong recovery BofA stock is still trading some 30% below our initial recommended entry price. So, depending on how one executed the entry strategy, one would be some 10-15% down even today.
The question now is: Do we keep our position or get out and lick our wounds?
Something I learned long ago is that the very best investments take years to materialize. And this will be true for our Bank of America investment as well.
The reality is that Bank of America has become even more dominant today than we envisioned back in October 2008. Almost every premise that we sustained back then is valid today. Simply put, our purchase - just like Bank of America's purchase of Merrill Lynch - was just a few months early. Consequently, we overpaid - but that is behind us now and we must focus on the future.
Today, the recovery in the bank's shares is indicative of BofA's strong fundamentals. The company blew through earnings expectations, along with its peers - JPMorgan Chase & Co. (NYSE: JPM) and Citigroup Inc. (NYSE: C).
Along with Goldman Sachs Group Inc. (NYSE: GS) the top six banks showed record profits of $18.7 billion. That was six times larger than last quarter, a record since the financial crisis and the largest profits since the spring of 2007.
That's a strong recovery theme across the board.
In Bank of America's case, the prize goes to sales and trading, which posted a record $7 billion in revenue, suggesting its acquisition of Merrill will prove correct in the long run. With a concentrated marketplace in the investment bank arena, Merrill Lynch has an easier time at capturing superlative profits on a day-to-day basis.
BofA's home mortgage business is still generating strong losses, but those losses are decreasing - an indication that the bank has turned the corner. The bank took $9.8 billion in reserves against bad loans, down from $10.1 in the prior quarter, and down from $13.4 billion a year earlier.
As different areas of the country eventually see their housing markets bottom, the stage will be set for a very strong rebound in profits for this giant. Once we get over the hump in home losses - and so long as we don't see a meltdown in commercial real estate - then BofA is going to see much stronger earnings than it is now.
In the meantime, traditional lending activities are still under pressure, mainly because of a lack of loan demand. The recovery continues to be sluggish and both individuals and corporations are reluctant to take on leverage, which negatively affects banks' net interest margin.
But this deleveraging by Bank of America's consumer and business clients could be the precursor to a strong recovery. Already the caution is leading to improving credit metrics. Credit quality keeps improving and bad loans appear to have peaked.
BofA, meanwhile, keeps strengthening its balance sheet. Its capitalization is sky-high with Tier 1 capital of 10.2%. And the bank is awash with liquidity, which keeps strengthening. Global excess liquidity has increased by $50 billion to more than $260 billion.
Another thing working in BofA's favor is the extremely lax monetary policy. This policy will eventually change, but by the time that this happens, the bank will be experiencing a much, much lower level of charge-offs.
So, based strongly on these fundamentals, I would stay invested in Bank of America and use every pronounced drop in the markets to add to my position. In the long term, the bank will finalize its restructuring, and as profitability becomes normalized, we could easily see more than a double. You see, the bank is trading at a 20% discount to book. So expecting even a double here is quite conservative.
However, I would advise some caution.
In the past few days, the Securities and Exchange Commission (SEC) has accused Goldman Sachs of fraudulent behavior in the securities markets. It is conceivable that this could be the first in a series of actions directed at punishing Wall Street. I try to predict judicial outcomes, so I will not make any prognostications with respect to the possible outcomes of Goldman Sachs. But, even though we do not have any indication that this situation could affect Merrill Lynch, we need to be cognizant that the US government might try to go after other participants in the collateralized debt obligations (CDO) market.
Also, the Obama administration is attempting to enact reforms in the financial markets with respect to regulation. It is unclear which reforms might be enacted and what the effect of these reforms will have on the earnings outlook for the banks. Should limits on growth be implemented to try to avoid the "too-big-to-fail" syndrome, Bank of America's growth outlook would be relatively damaged compared to its much smaller rivals.
Similarly, if regulation becomes too onerous, banks' profit margins could be severely reduced.
Additionally the timing of the eventual rate hikes by the Federal Reserve is clouded in uncertainty. An increase in interest rates will most likely reduce the net interest margins of the banking sector, including Bank of America. But the Fed will only proceed in this regard once it sees that a self-sustaining economic recovery is well ingrained. And that would mean declining credit losses, which means this should only be a small, temporary hiccup in bank of America's valuation when it occurs.
So, despite all the headwinds, the powerful restructuring that Bank of America has undertaken will eventually result in a much more profitable institution than it is today - and thus warrant a much higher valuation.
While I would not be increasing my exposure right now, ahead of that regulatory and judicial uncertainty, I would be alert and respond to any sizeable dips by adding to my position. I also would be prepared to hold long term, looking for a very strong return.
Bank of America dipped slightly by .11 to close at $18.43 Friday.
Recommendation: Buy Bank of America Corp. (NYSE: BAC). **
** Special Note of Disclosure: Horacio Marquez holds no interest in Bank of America Corp.
[Editor's Note: Horacio Marquez knows how to make a market call. It was Marquez who told investors that lithium was going to be big - a year before other "experts" made the same call. Now Marquez has isolated the major profit opportunities being created by the possible broadband breakdown - a situation that the news media is only just now starting to understand. To find out all about those top profit opportunities, check out this new report.]
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