Shares of Bank of America (NYSE: BAC ) have climbed significantly higher from their lows two years ago, and some investors believe that run is close to ending. In this segment of The Motley Fool's financials-focused show, Where the Money Is, banking analysts Matt Koppenheffer and David Hanson discuss Bank of America's valuation and look at the bank's future opportunities and hurdles.
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Full transcript below.
Matt Koppenheffer: Moving to our focus for the day, the focus is Bank of America. You and I had found an article last night, on Seeking Alpha. Not about calling people out, but it was an article titled, "Bank of America Should Trade Below Book Value."
The thing that jumped out at me is that, I think for the viewers and listeners of this show, it may seem surprising to hear somebody say Bank of America should trade below book value, because we're generally positive on it -- me a little bit more than you, I guess -- but that's not a crazy perspective, "Bank of America should trade below book value."
That's not the out-of-the-box thinking. That's more the market's thinking. The reason we know that is because Bank of America is trading below book value. But, from my perspective at least, I think this article missed some things, or at least I see the situation from Bank of America differently than the author did.
One of the things I'll start off with -- and then I'll let you, David, share a couple of your thoughts -- is just the general idea where I think a lot of investors get into trouble is looking at the numbers today, looking at the results today, and essentially looking at that situation and saying, "That's going to continue, out into the future, so this is how I'm going to value it, based on what's happening today."
The problem is, that that's the easiest way to project out into the future, so that's generally what the market is doing. As investors, the only reason we're going to bother investing in individual stocks is we want to find situations where we're going to beat the rest of the market. Otherwise, we should just be investing in passive index funds.
So, when you're looking at a situation where you are doing the exact same thing that the market is, in projecting it out, you're not going to find those opportunities, and I think that's what's going on here, at least in part, with Bank of America.
David Hanson: Yeah. I think you're right in terms of, the current performance is a heavy indicator of what it's going to be currently valued. If we think back to when Bank of America was trading at an even bigger discount to its book value -- at, what, a 60% discount? -- maybe a year and a half ago, it's because a year and a half ago, the current performance was horrible.
It was worse than it is today, so like you said, you can't take today's performance and say, "OK, if they're only having a 6% return on equity today, they're going to have that forever." I think that's a dangerous proposition.
Even if it doesn't trade above book value, it's at, what, a 30% discount today? So in order for this to be potentially a successful investment, and for that multiple to move up, it could move up to a 10% discount, and that's still moving in the right direction for investors.
Koppenheffer: A couple other notable issues, I thought -- one thing that the author pointed out was how big an impact the Volcker Rule is going to have on proprietary trading.
If we look back to 2006 -- this was before the crisis, long before the Volcker Rule -- trading account profits... now, none of the banks were really breaking out true proprietary trading, because nobody was really thinking as much in those terms then, but "trading account profits," as Bank of America termed it, was $3 billion. That was a revenue line, so $3 billion in revenue.
When you think about, maybe that's a 50% margin business, because when you have proprietary traders you've got to pay those guys well, otherwise they're going to go off and set up their own hedge fund.
If we think of that as a 50% margin business, you're at about $1.5 billion in profits, maybe. Again, that's assuming that all of that is proprietary trading...
Hanson: Which I'm almost 100% certain it is not.
Koppenheffer: And you would have some insight into that, right? Even at that level, that's about 7% of 2006 profits, so what we're talking about is a very small portion of Bank of America's bottom line.
Another thing that the author notes is leverage; that Bank of America and the other banks were levered way high before the financial crisis, and that helped boost returns on equity, which in turn boosted valuations. The problem is that today the leverage is at 9.2:1. Back before, in 2006, before the financial crisis, Bank of America was levered at 11.7:1, so not that much higher.
The other thing to note there is that this isn't a good environment to be levered in. There's not a lot of opportunity to lever up and do a lot of extra lending, and leverage is something that you can build fairly quickly. Obviously, the regulators are going to be tightening down the screws much more on leverage right now than before, but there's still room there for Bank of America to expand that out.
The last thing that I'll point out is that the author noted that 0.7% return on assets, which he said was roughly where Bank of America is now, was a new normal for banks, and that should be expected going forward.
The problem with that statement is that Wells Fargo is earning a 1.5% return on assets, and U.S. Bancorp is earning a 1.6% return on assets, so obviously 0.7% is not the new normal. Not to mention that all of this ignores the fact that Bank of America has legal settlements baked in there, has a lot of extra overhead dealing with working down, souring mortgages, and that sort of thing. All of that's going to come out over the next few years. That's going to boost returns on assets and everything else.
Hanson: Yeah, I agree.
Koppenheffer: That's it? You agree?
Hanson: I agree, and like you said, don't want to call anyone out. I think there were some very reasonable deductions in this article, as well as thinking, "OK, if it's trading below book value, why is that? Is it because the returns aren't there?" I think that's a good thing to recognize; I just think some of the points in terms of why it won't get to a higher level of profitability may be a little off-base.
Koppenheffer: I think what it is, is a good illustration of where the market's thinking is right now.
Koppenheffer: This is where the market is valuing Bank of America, so this is a pretty good distillation of what the general market is thinking, and why it has Bank of America valued where it is.
Hanson: And I think the market's probably stuck on that number because it's hard to project, what does the profitability look like in a couple years, because it depends on a lot of things. It depends on them reducing expenses, it depends on interest rates. I think the market's saying, "We don't know what two years looks like from now, so let's just base it on what we know today."