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The suggestion that shares of Bank of America (NYSE: BAC ) will outperform those of Wells Fargo (NYSE: WFC ) over the next 12 months may seem farfetched given the banks' disparate reputations. Yet it's for this very reason, as well as the three discussed below, that I believe it to be the case.
There's a famous saying in the banking industry that investors should "buy at half and sell at two," referring in both cases to book value. Just like any other stock, the objective is to buy low and sell high.
If you accept this as true, then it's almost impossible to conclude that Wells Fargo is a better buy than B of A. Is Wells Fargo a better bank? Yes. Does Wells Fargo make a ridiculous amount of money compared to B of A? Absolutely. Will Wells Fargo continue to make more money than B of A, and most other blue-chip companies for that matter? Sure.
But you know what that means? It means you have to pay a pretty penny for Wells Fargo's stock. Shares in the nation's fourth largest bank by assets, and largest mortgage originator by far, trade for a dear 1.6 times tangible book value. Meanwhile, shares of B of A trade for a comparatively modest 0.88 times tangible book value.
The takeaway here is simple: Shares of B of A can go a lot higher without abutting unsustainable valuation levels, while Wells Fargo's cannot.
2. Resolving legacy issues
Now, whether or not shares in B of A will go a lot higher is another question entirely. The answer to this is first and foremost a question of the lender's so-called "legacy" issues.
In 2008, B of A made the colossal mistake of acquiring Countrywide Financial, the largest mortgage originator in the nation at the time. As the bank's then-CEO Ken Lewis said: "Countrywide presents a rare opportunity for Bank of America to add what we believe is the best domestic mortgage platform at an attractive price and to affirm our position as the nation's premier lender to consumers."
Talk about famous last words. B of A has since come to realize that it bedded down with a former criminal enterprise. And while figures of the resulting legal liability assumed by B of A are difficult to come by, at the very least, and I mean the very least, it's cost B of A $40 billion in charges related to litigation and settlements -- as a side note, my guess is that the total cost is closer to $100 billion.
It's for this reason, in turn, that B of A's shares trade for such a paltry valuation, as its earnings continue to be consumed by losses dating back to the financial crisis.
Importantly, however, this is coming to an end. Earlier this month, B of A announced two massive legal settlements; one with Fannie Mae related to Countrywide's faulty underwriting process, and the other with regulators related to suspect mortgage-servicing practices.
While these settlements eviscerated a staggering $5 billion in B of A's earnings in the fourth quarter of last year, they also accounted for a large proportion of the outstanding claims against the bank. In the press release announcing the settlements, B of A estimated its remaining liability for "both GSE and non-GSE representations and warranties exposures to up to $4.0 billion at December 31, 2012, compared to up to $6.0 billion at September 30, 2012."
Is $4 billion a lot? Yes. Does is feel good for B of A's shareholders? No. But is it manageable for a bank that can earn roughly that amount in one quarter? Absolutely.
As a result, at some point, and I believe it'll be this year, a significant portion of B of A's earnings will be freed up to be just that: earnings. And when this happens, shares of the lender will accelerate the same ascent that sent them soaring last year.
3. Capital and dividends
The final reason that I believe B of A will outperform Wells Fargo this year has to do with the interplay of capital and dividends.
Despite all of B of A's problems, there's no question that it's well-capitalized. At the end of 2012, its Basel III Tier 1 common capital ratio stood at 9.25%. This was the highest among too-big-to-fail banks, and is 75 basis points above B of A's mandatory 8.5% ratio. Reducing the figure to dollars and cents, it also means that the bank is sitting on $10.4 billion in capital beyond what's ostensibly required -- not to mention, the heightened 8.5% requirement won't even be fully phased in until 2019.
Consequently, there remain fewer and fewer grounds for the Federal Reserve to turn down a presumed request by the bank to up its dividend or initiate a share repurchase program. And to say that such a move would serve as a catalyst for B of A's share price would be an understatement, as I believe it could send them up toward the tangible book value range.
The bottom line
At the end of the day, there's simply no question that B of A presents more opportunities for share-price appreciation than Wells Fargo does this year. Yet, it also comes at the cost of risk, as Wells Fargo's earnings are a known quantity, while B of A's remain sporadic given its ongoing legal problems.
To learn whether the risk is greater than the potential return in this case, I encourage you to download our in-depth report on B of A. Among other things, it concludes with the prediction that shares in the bank could double or triple over the next five years. To claim a copy of this valuable report instantly, simply click here now.