The Historical Case for Buying Bank of America's Stock Today

If Bank of America's (BAC 3.35%) performance throughout the 1980s is any indication, and I think that it is, then there's reason to believe that its still-nascent recovery could soon take the shape of a sudden and dramatic increase in profits.

Bank of America and the tumultuous 1980s
The 1970s were heady times for banks. The United States hadn't experienced a banking panic since 1933 -- an unusual period of calm in a country that had previously experienced one every decade. World War II cemented the United States' lead in global finance. And the rapid accumulation of petrodollars from oil-producing countries filled banks with an abundance of inexpensive deposits.

The decade's high-water mark was 1979. Of 100 lenders surveyed that year by Salomon Brothers, the average increase in earnings over the prior year was an astounding 29.6%. The performance "widely eclipsed any previous year in modern banking history," noted the investment bank.

Bank of America was no exception. It reported record earnings every year from 1970 until 1980. Its CEO was recruited to head the World Bank. And the California-based lender was expanding its operations around the globe, buying consumer banks in multiple international markets.

But everything came to an abrupt halt in 1981. Loan portfolios started reaping what the banks had sown during the petrodollar-fueled credit frenzy of the 1970s. Commercial real estate loans began failing. Agricultural loans did too. And, most problematically for Bank of America, foreign countries that had borrowed from U.S. banks were buckling under the pressure of burdensome interest payments.

To top things off, the Federal Reserve was attacking 12-14% annual inflation by raising the federal funds rate -- one of two key short-term interest rate benchmarks in the United States -- to as high as 19%. This meant that Bank of America and similarly situated lenders were paying nearly 20% to borrow money while many fixed-rate loans on their books yielded 8% or less. In banking lexicon, it was a textbook case of "mismatch."

Things deteriorated so much at Bank of America that analysts, commentators, and even regulators questioned whether it would survive. There were "rumors in the street that Bank of America was close to bankruptcy, that the Comptroller of the Currency and the Federal Deposit Insurance Corporation (FDIC) were preparing to swoop down and bail out or sell off 'capitalism's greatest prize,'" wrote Moira Johnston in Roller Coaster: The Bank of America and the Future of Banking. 

Its $955 million loss in 1987 was the second-worst annual deficit for a bank on record, eclipsed by only Continental Illinois' $1.1 billion loss three years earlier. It was an ominous association to say the least, as Continental Illinois was nationalized by the FDIC in the summer of 1984.

Slowly but surely, however, Bank of America turned things around:

• It charged off billions of dollars' worth of loans to faltering Latin American governments, as well as to farmers and real estate developers in the United States.
• It auctioned off its headquarters building in San Francisco and shed dozens of non-core operating divisions, including its prized Italian banking subsidiary Banca d'America d'Italia and the discount broker Charles Schwab & Co.
• It laid off thousands of employees.
• It replaced both its chairman and chief executive officer, eventually filling its executive ranks with transplants from Wells Fargo.
• And it eliminated its quarterly distribution to shareholders.

By 1988, Bank of America was not only making money again -- albeit with the help of asset sales -- it was earning more on an annual basis than it had since its founding 84 years earlier. It generated $720 million in net income in 1988, $1 billion in 1989, and, by the mid-1990s, it was earning just short of $2.5 billion a year.

 "It's not that they have just recovered; it's a different company," observed an analyst with Keefe, Bruyette & Woods at the time.

Bank of America and the financial crisis of 2008-09
It's through this lens, and the immediately preceding chart in particular, that I believe investors should view Bank of America's burgeoning recovery from the financial crisis of 2008-09.

This isn't to say that Bank of America's recovery from the latest crisis will trace the exact same trajectory. The episode seven years ago was more severe than the combined crises of the 1980s. Additionally, the regulatory environment nowadays is more burdensome than it was three decades ago, mandating in particular that banks operate with less leverage and more highly liquid assets.

But even after you take these differences into account, it still seems reasonable to conclude that Bank of America's recovery, once it arrives in full force, could be as fast and furious as it was three decades ago.

• Loan losses have dropped precipitously at the nation's second biggest bank by assets, falling from 3.6% of total loans in 2010 down to 0.56% in the first quarter of this year.
• Core operating expenses have declined by an estimated $8 billion a year.
• And the oppressive legal fees that have plagued Bank of America since the onset of the crisis are almost certainly in the rearview mirror, or, at the very least, nearly there.

It's also important to appreciate that, thanks to low interest rates, banks are earning less on their assets than at any time in modern memory. JPMorgan Chase, the nation's largest lender, predicts that it will earn $4.5 billion more a year by 2017 if short-term rates normalize around 2.25%. Bank of America estimates (see table below) that its annual net interest income will climb by $2.2 billion if rates increase by a single percentage point.

Source: Bank of America's 1Q15 10-Q, page 109.

With this in mind, Bank of America's executives have begun claiming that it could earn 1% on its assets, or $21 billion a year, once the bank has fully and finally worked through its remaining legacy issues. "[B]ased on everything we see . . . you do see us move toward those long-term goals of 1% return on assets and 12% return on average common equity," said CEO Brian Moynihan on the company's first-quarter conference call earlier this year.

If it's able to do so on a sustainable basis, it isn't unreasonable to think that Bank of America's stock will trade for 1.5 times book value or more. This calls for an eventual doubling of its current stock price based on valuation alone, given that its shares presently sell for a 21% discount to book value.

The question, in turn, is whether this makes Bank of America's stock a buy. While I'm starting to believe the answer is "yes," an important qualification is in order.

Unlike Wells Fargo or U.S. Bancorp, Bank of America isn't a set-it-and-forget-it kind of stock. Every few decades it runs into problems -- and, when it does, its shareholders suffer. In the latest crisis, it not only lost an unconscionable amount of money, it also egregiously diluted its stock. Its book value per share even today is 33% less than it was in 2007.

On top of this, it shouldn't be assumed that Bank of America will ever generate the same degree of profitability as its one-time neighbor, Wells Fargo, which has consistently outperformed Bank of America through both good times and bad.

That being said, if you're comfortable with the risk of owning Bank of America's stock, and you believe that its current valuation adequately compensates investors for its comparatively pedestrian profitability even under the best-case scenario, then I think the case for buying its stock is compelling.