What Bank of America Bulls Don't Understand About Banking

I think it's fair to say that most analysts and commentators are bullish on shares of Bank of America (NYSE: BAC  ) . And while I respect their opinions, I also believe they're wrong.

The error in their collective analysis is that they've largely ignored, or otherwise diminished, the two most important variables that dictate a bank stock's long-term shareholder returns. It's a bit like baking a cake with salt instead of sugar -- that is, you'll likely discover the mistake only after it's too late to fix it.

With this in mind, I've set out to demonstrate not only where the collective judgment on Bank of America is right, but also specifically where and why it's wrong. And while I'm hesitant to make any guarantees, I believe that a reader who makes her way through this column will emerge with a rare appreciation for the precise factors behind the world's best bank stocks.

The bullish case for Bank of America
The argument in favor of buying stock in the Charlotte, N.C.-based bank goes something like this. Bank of America overseas a collection of the most valuable and recognizable franchises in the American financial services industry. These range from its well-known consumer-banking business to investment banking to its industry-leading wealth management division acquired via its 2008 purchase of Merrill Lynch -- click here for a recent in-depth rundown of Bank of America's business divisions.

The one exception to this is its consumer real estate division, which has been responsible for the majority of Bank of America's woes since the financial crisis. Fortunately, so the argument goes, these troubles have almost completely been atoned for following a corporate reorganization, tens of billions of dollars' worth of legal settlements, and the bank's decision to abandon the mortgage products and third-party lending channels that are widely (and accurately) attributed with causing the debacle.

Given this progress, the argument continues, it's clear that Bank of America's shares are "cheap" because they trade for a large discount to better-heeled competitors like Wells Fargo (NYSE: WFC  ) and JPMorgan Chase (NYSE: JPM  ) . For instance, shares of Wells Fargo trade for 1.72 times book value, while Bank of America's trade for a miserly 0.74 times book.

It's urged this gaping divide will compress once interest rates increase, and thereby boost Bank of America's net interest income on its trillion dollars' worth of deposits -- once its remaining legal woes are finally in the rearview mirror, and once investors and analysts stop vilifying Bank of America for its previous misdeeds.

The problem is not the premises; it's the conclusion
Now, just to be clear, I don't necessarily disagree with any of these premises. At various points over the last few years, in fact, I've both owned Bank of America shares and made many of the same arguments myself. Had you asked me two years ago or even last year, I would have been the first to say that Bank of America was a "buy."

The problem is, its share price has risen considerably since then. Over the last year, it's up by 27%. Over the last two years, it's up by 97%. And since bottoming out at the end of 2011, it's up 213%.

BAC Chart

There's no getting around the fact that this makes Bank of America's stock a significantly riskier and less profitable investment going forward. If you already own it, then you're likely sitting on considerable gains and thus have a comfortable margin of safety. But if you're thinking about buying now, you don't have this same cushion.

On top of this, while all of the bullish arguments are individually valid, they don't support the conclusion that Bank of America is a good investment at today's price. By "good investment," I mean one that promises outstanding investment returns relative to competitors -- this last (italicized) part is extremely important, because you should always consider the opportunity cost of investing in one stock relative to another.

Indeed, the problem with most mainstream bullish arguments for Bank of America is that all of them miss the most important points. The purported value or dominance of various business lines is a subsidiary issue; it's necessary but not sufficient to produce outstanding returns. And the same can be said of Bank of America's outstanding deposit franchise, as well as its ongoing efforts to cleanse its balance sheet of legacy assets dating back to the financial crisis.

The dark side of revenue maximization
Ironically, the issue here is that most of these things drive revenue. And, while you may be surprised to hear this, revenue isn't correlated to how well a bank stock performs over the long run. Yes, you read that right; there is essentially no correlation between a bank's revenue and its shareholders' long-term return on investment.

Boosting revenue at a bank is easy -- embarrassingly easy. This is because a large portion of revenue at most banks (Bank of America included) stems from lending. Consequently, if you're a banker set on boosting revenue, which most bankers are, all you have to do is reduce your credit standards and make more loans at lower interest rates.

Sound familiar? It should, as this is the very behavior that produced the financial crisis. And, for the record, the 2008 crisis was hardly an anomaly, as financial history is littered with similar panics that have caused the downfall of thousands of banks irrespective of the size, power, and prestige of their reputations, business lines, or deposit franchises.

The problem is that loose lending with an eye toward boosting revenue invariably sows the seeds of subsequent destruction in shareholder value, either through a complete failure (e.g., Washington Mutual) or through egregious dilution of shareholders (e.g., Bank of America and Citigroup). Indeed, in the last crisis, there were only a handful of large banks across the country that escaped similar fates.

For fans of Warren Buffett, this is what he refers to on multiple occasions throughout the years by writing, "You only find out who is swimming naked when the tide goes out." In this case, the tide serves as a metaphor for the credit cycle.

What really matters: The efficiency ratio
At this point, you may be wondering: If revenue doesn't matter, what does? There's a part of me that wishes the answer to this was complicated, but the truth is that it's deceivingly obvious. Namely, what matters is how much revenue a bank is able to shuttle to the bottom line over multiple cycles.

If you break this down further, there are two components to it. First are operational expenses. The metric used to measure this is the efficiency ratio, which gauges the percent of revenue (or, more specifically, pre-tax pre-provision profit) that's consumed by noninterest expenses like salaries, rent, and incidentals. Speaking very generally, what you're looking for is a ratio in the 50% to 60% range.

U.S. Bancorp (NYSE: USB  )  serves as a textbook example. The massive regional bank headquartered in Minneapolis, Minn., regularly reports a ratio within a hair's breadth of 50%. This means that roughly half of every dollar in revenue ultimately makes its way to U.S. Bancorp's shareholders by way of dividends, buybacks, or book value appreciation.

And the same can be said of other top-shelf American lenders. In 2013, Wells Fargo's efficiency ratio was 58%, M&T Bank's was 57%, and thanks to a unique business model focused on large multifamily developments, New York Community Bancorp's came in at an astounding 43%.

So, how does Bank of America stack up? It's on the other end of the spectrum, with an efficiency ratio in 2013 of 77% -- though, to be fair, this was certainly an improvement over 2012, when it was 86%. With this in mind, it should come as no surprise that Bank of America's shareholders have fared considerably poorer over the years than the shareholders of its more efficient competitors.

What really matters: Loan losses
This brings me to the second main driver of shareholder returns for a bank -- prudent management of credit risk (or, more tangibly, loan losses). To be clear, that I'm discussing this after the efficiency ratio shouldn't be interpreted as a sign that risk management is less important. In fact, nothing could be further from the truth, as a bank's history of loan losses is the single most important variable when it comes to predicting a bank's long-term returns.

This is something I analyzed at the end of last year, and the results were staggering. Not only were loan loss provisions highly correlated with profitability at the nation's 18 largest lenders between 1995 and 2012, the correlation was leaps and bounds tighter than any other metric. I won't get into the statistical details now, as you can access the article I wrote on it here, but provisions were more than twice as correlated to compound annual returns over this period, relative even to asset growth!

The reason for this is simple. To Buffett's point about the tide, when the credit cycle turns against an imprudent lender, one of two things will inevitably occur. Either the lender will go out of business completely, or it will be forced to dilute shareholders by raising capital at the worst possible time -- that is, after its share price has plummeted because of suspicions or actual revelations about the quality of its loan book.

This is the reason former industry darlings like Bank of America, Citigroup, and Huntington Bancshares decimated shareholders following the financial crisis, as they were in desperate need of capital to fill the gaping holes in their balance sheets left by soaring commercial and residential loan losses.

Now, the bullish argument is that lenders like this learned their lesson and aren't apt to repeat the same mistake in future cycles. By this line of reasoning, in other words, these are probably the safest banks to invest in -- far more so than, say, a U.S. Bancorp or Wells Fargo, both of which emerged from the financial crisis bigger and stronger.

In support of the former proposition, some analysts will cite statements by bank management that things are different. If you find this absurd, then you're in good company, as I do as well. But for those of you who aren't in agreement, let me offer two points. First, what do you expect management to say? And second, the sentiment behind statements like these may be genuine, but they're nevertheless naive and likely to be disproved during the next cycle.

According to my reading of history, once poor lending standards or some other form of imprudent risk management take hold at a bank, they can't be easily eradicated. And by "can't be easily eradicated," I mean that it would be manifestly (small "f") foolish to think otherwise. There are few banks that prove this as well as Citigroup, which has found itself hobbled (and existentially so if it hadn't been for repeated government bailouts) in most if not every financial calamity since and including the Great Depression.

My point is that if you want to forecast how a bank will perform in the next credit cycle, you should look at how it performed in the last one, and not base your opinion on self-interested statements of management. And, at least on this count, I hope we're all in agreement that Bank of America has left a lot to be desired over the last few years.

The Foolish takeaway
After all of this, I'd urge you to take two things away from the discussion above.

First, I hope to have demonstrated why Bank of America, at today's price, is probably not the bank stock a typical investor wants in their portfolio. If it were patently cheap as it was two years ago, the story would be different. But it no longer is. Consequently, do yourself a favor and stick with lenders that have demonstrated histories of behaving appropriately throughout all stages of the credit and interest rate cycles. As I've already mentioned, the four that come immediately to mind are U.S. Bancorp, Wells Fargo, M&T Bank, and New York Community Bancorp.

And the second point is that you should be particularly wary when analyzing the banking sector (or reading another's analysis of it), as the same rules that govern most other industries -- and specifically with respect to maximizing revenue -- can often produce the opposite result when it comes to the business of lending.

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Read/Post Comments (12) | Recommend This Article (22)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 25, 2014, at 7:58 AM, Rifleman3006 wrote:

    Interesting that I don't see the best stock buyers in the world like Bruce Berkowitz dumping his shares? I think that if Buffett thought the stock had it's run he would exercise his options and run as well. He is NOT going to sit tight for a lousy 6% interest, that is way below is normative returns. So when investors such as these bolt, I may agree with you. Just because the stock has doubled over the last year or two doesn't mean it's seen it's day. Frankly all the pieces are actually coming together quite well and earnings projections are very nice indeed going forward. Why would anyone dump now unless they see what appears to be a better opportunity?

  • Report this Comment On June 25, 2014, at 10:06 AM, TMFHurricane wrote:

    Nice article, John.

    I don't flat-out disagree with really any of this, but it should be noted that the business composition is drasticly different today than at any other point in BAC's history. And I would argue that BAC's downfall was because of poor acquisitions and due diligence rather than poor loan underwriting. BAC was held in that class of conservative banks before the crisis but ML and Countrywide soiled the books that otherwise might have been okay.

    At the end of the day, everything depends on them making good loans. If you believe they can, the stock is cheap. If you don't (which is very reasonable to think), it's not.

  • Report this Comment On June 25, 2014, at 10:49 AM, anash91 wrote:

    Thanks for the article. I was ready to buy some because I liked the business, but seeing everything in perspective, I think I could generate better returns via other banks, and I may end up buying CITI or Wells Fargo instead.

  • Report this Comment On June 25, 2014, at 1:19 PM, pondee619 wrote:

    John Maxfield today (6/25/14): "Bank of America, at today's price, is probably not the bank stock a typical investor wants in their portfolio."

    John Maxfield two days ago (6/23/14): "Two years ago, I agreed with Brendan and thought Bank of America was a buy. But today, I believe it's a hold."

    John: Why should I hold a stock that is not one a typical investor would want in their portfolio?

    Did the price change that much in two days?

    P.S. You haven't yet exlpained your "hold" call of two days ago, as I requestsed. I now am led to believe that it means sell as I , as a typical investor, would not want BAC in my portfolio

  • Report this Comment On June 25, 2014, at 1:38 PM, JohnMaxfield wrote:

    Rifleman,

    I don't know what Berkowitz's basis in BAC's stock is, but given the terms of Buffett's deal, he has a large margin of safety in his position. At today's price, the margin of safety (if there is one) would be much smaller.

    To quote Buffett on this point:

    "The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do. For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments."

    Also, to your point about dumping shares; here's what I wrote about current BAC investors:

    "If you already own [BAC], then you're likely sitting on considerable gains and thus have a comfortable margin of safety. But if you're thinking about buying now, you don't have this same cushion."

    John

  • Report this Comment On June 25, 2014, at 1:47 PM, JohnMaxfield wrote:

    pondee619,

    I apologize for not responding to your last comment. I saw it and this article was, in part, meant to be my response.

    That being said, here's the quote from the article above that probably best answers your question (it's a bit repetitive because I also quoted it in the previous comment):

    "If you already own [BAC], then you're likely sitting on considerable gains and thus have a comfortable margin of safety. But if you're thinking about buying now, you don't have this same cushion."

    So, to your point, I suppose my wording in the sentence you cited should read: "Bank of America, at today's price, is probably not the bank stock a typical investor wants TO ADD to their portfolio."

    John

  • Report this Comment On June 25, 2014, at 2:32 PM, shamapant wrote:

    Love the article, if I don't agree with it. You make some good points, but if Berkowitz and Buffett are in it you have to wonder if you're missing something. Now it's true, follow your own analysis, don't blindly follow the experts, but I think that it's not too hard to find what you're missing:

    At this point no one is investing in BAC because it's a better bank than WFC or others, they're investing in it because given its deposit network and brand, it should be worth at least book value. It's just a question of where value really is, and while you point out some good reasons not to trust improvement, it's all very hand wavey until you give us a number for what you think BAC is worth.

    And that's what Berkowitz and Buffett did, they probably saw arguments like this one, but valued BAC at something like $20 or $25 and decided to invest anyways. Every investor has to come up with that number themselves though. I appreciate your analysis, very well thought through if missing a definite conclusion.

  • Report this Comment On June 25, 2014, at 4:37 PM, pondee619 wrote:

    John:

    Thanks for your reply, but, why should I continue to put my "margin of safety" at risk by holding a stock that is inferior to others in the same segment? Losing "house money", that is on my side of the table, are still my losses. I am doing this by holding BAC in lieu of swapping out for a better bank, as you seem to infer? A larger "margin of safety" is only good in the short term, comparitively speaking, if the long term prospects of the issue are good. No? Isn't holding an inferior stock akin to throwing good money after bad?

    If BAC is an inferior stock holding today, compared to its segment peers, and , of course, looking Foolishly long term, what is the rational for holding instead of swapping out for those better issues?

    The only reason, in my mind, to hold a stock that I would not want to add to is because its short term prospects are inferior to the market, or the stocks market segment, but its long term prospects are better, or at least as good. Is this what you are saying about BAC?

    Truth be told, I feel the call "hold" to be a major cop out and a dis-service to your readers. (Cramer's "Don't Buy" is equally poor) My money should always be working as hard as it can looking far down the road. A stock I hold should be one I want to buy unless there is a short term reason not to. A spike in the issues price might be such a reason. I truly do not believe that I should put my recent earnings at risk if the long term prospects of a company, and its stock priice, are not , at least, as good as its peers.

    A "hold" call requires much more explaination than a "buy" or "sell" call. The later two are just statements that one feels that the long term prospects are either good (buy) or poor (sell). A "hold" call requires a clear statement of the short term risks and the long term benefits of holding.

    Why would I want to hold a company that I would not want to add to? The only reason is that current short term problems exist (maybe just valuation) but long term the company shows promise.

    I don't think that this is your position on BAC. Am I wrong?

    thank you:

  • Report this Comment On June 26, 2014, at 12:18 AM, phexac wrote:

    The argument that if you own stock and have had gains you should hold it but you should not buy it is terrible and is an example of all sorts of biases distorting the correct way to analyze a security. Every dollar invest in BAC is indentical to cash you could either hold as cash or use to buy another investment. The point of entry does not affect the quality of an investment. Your "margin of safety" is nothing more than fear of loss dictating that as long as you see green numbers next to a stock in Google Finance, you are ok. It's bad reasoning for investments, both current and potential.

    Given your mode of thinking, it isn't terribly surprising that you miss the basic point that for a company that earns over 10 billion a year in profit, a 10-billion dollar settlement is inconsequential for its long term potential. This particularly surprising, given MF's philosophy of holding stocks for decades. Though I guess it's less surprising given your demonstrated lack of basic understanding regarding the point of entry's irrelevance for the buy/sell decision. Whoever's letting you post articles on this site is doing MF's reputation a major disservice. Sorry to be harsh, but uh, welcome to the internet (and real world).

  • Report this Comment On June 28, 2014, at 12:58 AM, CoreAndExplore wrote:

    I couldn't disagree with phexac more. "Point-of-entry" as you term it, is indeed CRUCIAL when determining whether or not you're making a good investment. Just because a company may have really good future prospects, that alone does not make a sound investment, even over the course of many years, depending on the valuation. If you're not concerned with the price paid for each dollar of earnings and future earnings potential, then you could be in for a decade+ of miserable risk-adjusted returns.

    Many investors who piled into Tesla, LinkedIn, Lumber Liquidators, Twitter, Whole Foods etc. which ALL have fantastic growth prospects, did so at obscene valuation levels. Will those investments pay off? No, not given an appropriate required rate of return. While you are right in the sense that you can hurt yourself by waiting for the perfect entry point, which usually never arrives in the best growth stocks, you'd be equally as foolish (small "F") to blindly throw money at a company simply because future prospects are bright. Price paid is critical to investment success, PERIOD.

    BTW, very nice article, John.

  • Report this Comment On June 28, 2014, at 12:05 PM, sebastianpurcell wrote:

    John,

    I think I’m in disagreement with you on this one (though I’d have to say thank you for the healthy skepticism).

    Objection 1: The Efficiency Ratio

    I think you are pricing in the legal settlement fees – which is exactly what a value investor shouldn’t be doing at this point.

    In order to make your case against BAC, your numbers include “Legacy Assets and Servicing” which is part of the Consumer Real Estate Services (CRES) – formerly Country Wide. So yes, BAC performs poorly, but that is because you are pricing in the legal settlement fees. If you were to take out those fees, I imagine it would turn out that BAC performs about as well as the industry average (I haven’t done this yet myself, but aim to do so after your article – again thanks for the healthy skepticism). Going forward, BAC even has a plan for better performance here.

    In short, with the right numbers, your argument points towards a Buy not a Hold or Sell.

    Objection 2: Valuation Confusion

    Even if your argument about the efficiency ratio were right, it would be an argument against the growth of the company. The low price to book value of the company suggests a bargain buy, not a growth buy. Even trading at a discount to its peers, BAC should at least be worth its book value.

    Buying in now, then, an investor is bound to earn something going in, regardless of growth performance. The company is just irrationally priced too low because of Mr. Market’s hysteria concerning the DOJ.

    Objection 3: Selective Growth Assessment

    While you are right to point to measures for growth and performance, primarily the efficiency ratio, your analysis is in error on two counts.

    First, your argument unsupportibly oversimplifies BAC’s operations. You’re argument against revenue increase (on which measure you agree BAC performs well) is that this sort of increase can be inflated by bad loans. This is true, but you have failed to acknowledge that the healthiest portions of BAC’s growth have little to do with loans. BAC is an industry leader in global banking (charging fees, etc.) and global markets. Moreover, GWIM, its best performing division, is a leading capital allocation unit, not a loan lender.

    Second, the Consumer and Business Banking unit, which does make loans, is not presently acting responsibly. You site what could be a problem, but in fact, when checking over the numbers, this unit is IN FACT (and we’re not investing in a hypothetical bank here) performing responsibly. (See Jordan Wathen’s article on this point).

    These two errors in the analysis of growth lead to one conclusion: the increase in revenue will translate (in this case) to an increase in the bottom line. While the separation is always a concern, there are no reasons in this case to be concerned.

    My ultimate conclusion, then, is that I appreciate your article for its diligence in highlighting facets that pose real banking problems. Skepticism is always helpful when analysts become bullish. Nevertheless, I do not think the evidence you produce supports your conclusions.

  • Report this Comment On June 30, 2014, at 12:55 AM, SkepikI wrote:

    <I would argue that BAC's downfall was because of poor acquisitions and due diligence rather than poor loan underwriting. BAC was held in that class of conservative banks before the crisis but ML and Countrywide soiled the books that otherwise might have been okay.>

    Which, of course ignores that the idiots who made the "bad acquisitions" also made the "wonderful" loan underwritting. AND IGNORES the fact that only the head idiots were sacked leaving the remaining bums who went along to run the bank......

    BAC along with Citigroup are some of the least respected banks and businesses in the country. HOW in the world do you expect that the long term business will go well?

    this is an excellent article John and long on useful and believable analysis.... but it still does not get to the point of terminal illness: WHO does business with a bank that they cannot trust? Answer- not the kind of customers you want as an investor....

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