Bank of America (NYSE:BAC) has definitely come a long way since the financial crisis. The company's capital levels are vastly improved, its asset quality is significantly better, and the bank has been focused on building its core (lower-risk) businesses.
However, while Bank of America certainly has the potential to produce excellent returns, an investment in its stock is not without risk. Before you decide to add Bank of America to your portfolio, here are a few things you need to know.
Since the end of the financial crisis, Bank of America has made some notable improvements in its business.
For starters, its asset quality and capital levels have tremendously improved. The recent stress tests did result in a "conditional approval" of Bank of America's capital plan, but that was based on the bank's procedures for predicting its performance in a downturn and some issues with its internal controls -- not on a lack of capital.
In fact, Bank of America passed that last portion of the test with ease. Regulators found that in a "severely adverse" economic scenario, the bank's Tier 1 common capital ratio would fall to a minimum of 7.1%, well above the 5% minimum. Meanwhile, its Tier 1 leverage ratio would stay above 5%, comfortably above the 4% required by the government. In other words, Bank of America appears ready and able to deal with another severe recession.
Further, Bank of America is actively reducing its physical footprint in order to reduce expenses and run more efficiently. Since the financial crisis ended, Bank of America has been among the banks most aggressively closing branches; its network has shrunk from about 6,100 branches to approximately 5,000.
Finally, Bank of America is focusing more on its consumer banking business and making a strong effort to become the "one-stop shop" for its customers' banking needs by selling additional products to existing customers. During the last quarter of 2014, the bank opened 1.2 million credit card accounts, with about two-thirds going to existing customers.
So there are plenty of reasons to have an optimistic view of Bank of America's future.
But there are still plenty of risks
Bank of America is not a low-risk stock, and it's unlikely to be one anytime soon. Basically, the company has a long history of poor risk and credit management, and this hasn't really changed. In fact, as my colleague Jay Jenkins recently pointed out, Bank of America is releasing some of its reserves at a time when rivals such as Wells Fargo (NYSE:WFC) and JPMorgan Chase (NYSE:JPM) are building theirs up.
The bank's efficiency and performance also leave something to be desired. For 2014, Bank of America managed to produce a return on assets of just 0.23% and a return on equity of 2.52%. For comparison, Wells Fargo produced ROA and ROE of 1.45% and 13.41%, respectively, while JPMorgan Chase's respective figures were 0.89% and 10%.
To be fair, a lot of the negative performance had to do with legal expenses, but that's yet another area where shareholders have an ongoing risk. Sure, the record $17 billion settlement the bank reached this year took care of most of the outstanding mortgage-related issues, but B of A is not immune to further legal action.
The risk/reward could make sense -- if you know what you're getting into
There's no denying the potential of Bank of America. The company has an enormous branch network, more than $2 trillion in assets, and arguably the most recognizable brand name in banking. If CEO Brian Moynihan succeeds in changing the culture of Bank of America and mitigating risk and improving efficiency, shareholders could be handsomely rewarded. However, that remains a pretty big if.
For the time being, Bank of America trades for just 74% of its book value as of this writing, creating a pretty interesting risk/reward ratio. In other words, you can buy Bank of America for less than three-fourths of the value of its assets. (For comparison, Wells Fargo trades for about 1.75 times its book value.)
So, while an investment in Bank of America could certainly pay off over the long run, make sure you realize that you're taking on quite a bit of risk -- and be prepared to ride out the ups and downs while the company evolves.