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Why It Was Silly to Downgrade Bank of America Stock

By John Maxfield – Mar 1, 2016 at 5:18PM

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Bank of America's shares are safer now than they were two months ago, despite the fact that they were downgraded on Tuesday.

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After shares of Bank of America (BAC 2.30%) have lost nearly a quarter of their value since the beginning of the year, a United Kingdom-based research firm, Atlantic Equities, downgraded the bank on Tuesday from an "overweight" rating to "neutral." Aside from being late to the party, the move defies logic.

The implication that Bank of America's stock was overweight before the drop -- meaning that it appeared to offer a better value than other stocks -- but neutral now doesn't make sense. At the end of last year, Bank of America's shares traded for an 8% premium to the bank's tangible book value. Fast forward to today and its shares trade for a 28% discount to tangible book value -- and that's after Tuesday's 5% increase.

If you think about this logically, the drop in Bank of America's stock indicates two things. First, as my colleague Rich Smith pointed out, it means there's a larger margin for error if you were to buy the bank's stock today relative to two months ago. This isn't to say that Bank of America's stock couldn't fall further, because it could. But it's in the bargain bin as is, and its markdown is already very steep.

The second and related point is that Bank of America's stock is less risky today than it was at the end of last year. Risk boils down to how much an investor stands to lose by buying a stock. Doing so after a stock has fallen is thus necessarily less risky than buying it at its peak. This makes sense in theory, but our emotions lead us in the opposite direction, as we tend to underestimate risk when stocks are soaring and overestimate it when they're crashing.

It was this exact type of behavior that gave Warren Buffett an opening to buy shares of Wells Fargo at the beginning of the 1990s. There was a widespread belief at the time among analysts that banks were in trouble thanks to a downturn in the commercial real estate market. A prominent writer for The New York Times even intimated that the bank industry could "go the way of the savings and loans, becoming a government ward."

This void gave Buffett's Berkshire Hathaway the opportunity to become Wells Fargo's biggest shareholder at a steep discount to its historical valuation. "Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks," Buffett wrote at the time.

The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled-often on the heels of managerial assurances that all was well-investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.

Getting back to Bank of America, then, it's worth keeping in mind that the bank has meaningfully improved its operations and profitability over the past year. Its 2015 results marked the first time since the financial crisis that it reported four consecutive calendar quarters of respectable profits, producing its highest annual earnings in nearly a decade.

Just as significantly, Bank of America was able to partially slay two particularly pernicious demons last year. First, a judicial decision in the second quarter allowed the bank to slash its outstanding legal liabilities by $7.6 billion dollars. The holding also reduced the inflow of new crisis-related claims from around $2 billion a quarter to roughly $200 million. And second, Bank of America's debt rating was increased by a notch, which will ultimately result in a lower cost of funds and thus higher profits at the Charlotte, North Carolina-based bank.

To be fair, the world economy is in disarray. China's economy is teetering on the brink of an economic cataclysm, evidenced by the recent decision of its central bank to ease bank reserve requirements in an effort to reignite lending. Europe is also perched on the precipice of an unknown disaster, with voters in the United Kingdom set to vote in June on whether to remain in the European Union. And oil prices continue to spur fear among investors that banks could soon see a wave of defaults emanating out from the energy industry.

But with the exception of the upcoming referendum in the United Kingdom, none of these concerns are new. And the fact that Bank of America's shares already trade for a substantial discount to tangible book value suggests to me that the potential fallout from these events have been priced into Bank of America's stock. This isn't to say that they won't fall further, but they certainly look cheap to me.

In short, investors shouldn't allow themselves to be swayed by a belated downgrade of Bank of America's shares at the very same time that savvy investors see them as a bargain.

John Maxfield owns shares of Bank of America and Wells Fargo. The Motley Fool owns shares of and recommends Berkshire Hathaway and Wells Fargo. The Motley Fool has the following options: short March 2016 $52 puts on Wells Fargo. The Motley Fool recommends Bank of America. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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