Legendary investor Warren Buffett and his company, Berkshire Hathaway (BRK.A -0.59%) (BRK.B -0.74%), have really gone all in on Bank of America (BAC 0.45%), the second-largest bank in the U.S. by assets.
The conglomerate owns more than 1 billion shares of Bank of America, which equates to 12.9% of the shares outstanding. The stock is also now the second-largest position in Berkshire's roughly $324 billion equities portfolio, making up almost 11% of the total.
While the stock has sold off this year as investors fear a deep recession in 2023, the earnings outlook for Bank of America is really quite rosy right now. Here's why.
Operating leverage
Operating leverage is a key metric bank investors look for, and it's really great for any company to achieve because it simply means that revenue is growing at a faster rate than expenses. Following the third quarter, Bank of America has now delivered five straight quarters of operating leverage thanks to a few different factors.
Image source: The Motley Fool.
First, net interest income (NII), the profits banks make on loans and securities after funding those assets, has surged in the high interest rate environment. Higher rates result in higher yields on many bank loans and bond holdings, which can lead to bank margins widening if the bank can keep deposit costs from rising too much.
In the third quarter, Bank of America delivered $13.8 billion of NII, up $1.4 billion from the second quarter, which is more than management had initially forecast. Management expects NII to grow at least another $1.25 billion in the fourth quarter if the Federal Reserve's projected interest rate hikes materialize, and management also thinks it will be possible to keep boosting NII in 2023.
On the other side of the operating leverage equation, Bank of America has done a nice job of managing expenses. The bank only expects minimal expense growth for full-year 2022 compared with 2021, which is quite impressive when you think about inflationary pressures this year.
Furthermore, it looks like Bank of America is only planning for low-single-digit percent expense growth next year, which is very minimal as well. If NII keeps growing like gangbusters and expense growth is minimal, there is a very good chance for continued operating leverage next year.
Strong capital position
Facing higher capital requirements coming into the quarter, Bank of America responded quickly and now is in a strong position.
After annual stress testing by the Fed, Bank of America learned that the amount of regulatory capital it would need to hold as a percentage of its risk-weighted assets (RWA) such as loans was going to increase. This meant the bank would need to build capital, making many investors wonder what the outlook for share repurchases might be.
But the bank produced solid third-quarter net income, which boosted capital, and also reduced its RWA. At the end of the period, Bank of America had built a large buffer over its new capital requirements. The strong earnings coupled with higher capital levels allowed the bank to buy back $450 million of stock in Q3, and management expects repurchases to increase.
Furthermore, credit quality remains extraordinarily clean right now. Bank of America's allowance for loan losses is currently six times higher than the level of probable loan losses the bank anticipated in the third quarter.
Buffett knows how to pick 'em
There's obviously a lot of uncertainty right now, and the economy could officially be in a recession in 2023, but Bank of America's earnings are currently forecast to grow nicely next year.
Credit quality is still very good, and Bank of America is managing expenses well, experiencing robust NII. The bank also is likely to retain a strong capital position that allows it to continue repurchasing shares.
This probably is one of the reasons that Berkshire boosted its stake in the company during the early phase of the pandemic while it was selling other bank stocks. Bank of America benefits from higher interest rates and has the ability to navigate a difficult environment, which is why I think its outlook is still quite rosy.
