The past five years have been difficult for dividend investors. In an era of widespread tech disruption, the market has favored growth stocks that largely don't pay dividends. At the same time, many mature companies that do pay high dividends are usually threatened by that disruption. And dividend payers that do have strong businesses tend to trade at very high valuations.
But the banking sector is one area where investors can find dependable, rising dividends at reasonable valuations today. Technology growth stocks, last year's winners, have sold off on fears of higher interest rates, but most large banks stand to benefit from rising rates, which can boost their net interest margins. As such, banks may be excellent havens for risk-off older investors and retirees today. Among banks, perhaps none is better-suited for this risk-off cohort than Bank of America (BAC 1.70%).
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Warren Buffett's favorite
Warren Buffett sold many bank stocks last year, but he added to his Bank of America stake. Buffett's conglomerate, Berkshire Hathaway (BRK.A -0.34%) (BRK.B -0.01%), owns just over 1 billion shares, good for 11.4% of the Berkshire's equity portfolio, and its second largest public equity holding overall.
Why does Buffett love Bank of America so much? Probably for its conservative underwriting philosophy under CEO Brian Moynihan, excitingly named "Responsible Growth."
Responsible growth
Since Moynihan took over in 2010, Bank of America has largely stuck to its knitting with straightforward lending, while avoiding risks and exotic products like those that recently got several banks in trouble with hedge fund Archegos Capital Management. In the wake of the global financial crisis, the retooled "Responsible Growth" strategy has four pillars:
- We must grow in the market, no excuses.
- We must grow with a customer focus.
- We must grow within our risk framework.
- We must grow in a sustainable manner.
That risk framework is meant to be conservative, long-term-oriented, and focused on the bigger picture. As the strategy was implemented, Bank of America's net profits have become steadier and more consistent.
Even in the pandemic year, in which some banks saw earnings go negative, with some even needing to temporarily cut their dividends, Bank of America generated $17.9 billion in net income and maintained its payout, now yielding 1.82%. Thanks to conservative underwriting, net charge-offs only rose slightly, from $3.6 billion in 2019 to $4.1 billion in 2020. Being extremely well-capitalized, Bank of America has been given the green light to resume share buybacks by the Federal Reserve.
And investing in the future
While some believe traditional banks are under threat from digital fintech upstarts, the largest and best-run banks still have competitive advantages. These include large, nationwide bank branch networks, which enable lower-cost deposits, as well as the financial means to invest heavily in technology.
BofA has invested $18 billion in technology over the past six years, while opening 300 new branches and refurbishing 2,000 others. These tech investments have enabled even bigger cost cuts; operating expenses have declined from $57 billion in 2015 to $55 billion last year, despite $1.5 billion in extra COVID-19-related costs. And that's in spite of the company's decision to raise its minimum hourly pay to $20 per hour in that time.
Still a value play
Bank of America trades around 15.8 times this year's earnings estimates, in line with other large banks but still well below the overall market. Banks have generally had lower P/E ratios since the financial crisis amid low economic growth, low interest rates, and post-financial crisis regulations.
Still, Bank of America and other large-cap banks generated steady profits and high returns on equity during that time, returning cash to shareholders in the form of dividends and share repurchases. In essence, the large banks became more like dependable, low-growth utilities.
Yet those very capital regulations are what enabled the banking sector to weather the COVID-19 crisis relatively unscathed. Meanwhile, given the unprecedented amount of fiscal and monetary stimulus now coming into the economy, and with perhaps more on the way with a new infrastructure bill, the dual headwinds of low economic growth and low long-term interest rates could be reversing. Should interest rates rise, Bank of America would be likely to experience a rise in net interest income, given its loan-heavy business model.
Safety, dividends, and an inflation hedge
Large banks have generally proved to be safe amid this COVID crisis and stand to benefit from higher economic growth post-pandemic. If you wish to invest in the financial reflation trade, Bank of America is perhaps the best choice for low-risk dividend investors, such as retirees.
Yet while younger investors tend to invest in more flashy, growth-oriented companies, they could also benefit from Bank of America's staying power, growing dividend, and ability to thrive in a higher-rate environment.
In short, BofA is a solid choice for all types of long-term-oriented dividend investors... you know, like Warren Buffett.
