Few investors will ever forget the terror of the financial crisis of 2008-2009, when the global financial system was on the verge of complete collapse and many people were convinced we were headed for another depression.
Shareholders of U.S. megabanks such as Bank of America (BAC) were especially brutalized, when one of America’s largest banks came within a stone’s throw of complete insolvency and saw its shares fall over 90% from their all-time high.
Understandably, large banks have been incredibly out of favor since then, despite what has been one of the more impressive turnarounds in corporate America. In fact, Bank of America’s efforts allowed it to raise its dividend by 50% earlier this year, and more payout growth could be ahead. Warren Buffett owns a number of banks in his dividend portfolio as well.
Let’s take a look at just how far Bank of America has come since the dark days of the Great Recession and if its shares might represent a solid, if still high-risk, long-term opportunity for dividend growth investors.
Founded in 1874 and headquartered in Charlotte, North Carolina, Bank of America, with almost $2.2 trillion in total assets, is the world’s 9th largest bank and the 2nd largest U.S. megabank.
It primarily operates in four main business segments but with two thirds of net income coming from its core consumer and corporate banking divisions:
- Consumer Banking: providing retail banking services such as checking, savings, and money market accounts, as well as credit and debit cards through its 4,700 banking centers and 16,000 ATMs.
- Global Wealth & Investment Management: wealth management, brokerage, and retirement services.
- Global Banking: commercial, and real estate loans, revolving credit facilities, merger & acquisition consulting, debt, and equity underwriting
- Global Markets: market maker on numerous global exchanges, risk management, securities clearing, settlement, and custodial services, treasury bonds (helps US government sell freshly issued debt), and mortgage based securities
|Business Segment||Q3 2016 Net Income||% Of Net Income|
|Consumer Banking||$1.813 billion||36.6%|
|Global Wealth & Investment Management||$697 million||14.1%|
|Global Banking||$1.553 billion||31.3%|
|Global Markets||$1.074 billion||21.7%|
Source: Bank of America Earnings Presentation
When current CEO Brian Moynihan took over in 2010, Bank of America was a catastrophe. Under previous CEO Ken Lewis, the bank acquired both Countrywide Financial (the home mortgage originator) and Merrill Lynch; two decisions that Morningstar’s senior banking analyst Jim Senegal dubbed “some of the worst capital allocations decisions of all time”.
Mr. Senegal isn’t being hyperbolic, as Countrywide and Merrill Lynch ended up exposing Bank of America to over $200 billion in legal fines, compliance fees, and enough exposure to toxic debt that it nearly bankrupted the company.
Fortunately, Brian Moynihan is a completely different banker than Ken Lewis (who was a huge fan of risky speculation in highly leveraged mortgage backed security derivatives and credit default swaps), who has spent his tenure laser focused on creating a far more conservative banking culture.
This can be seen through three major initiatives:
First, Moynihan sold off much of the bank’s underperforming business segments to focus on the bank’s core businesses, which allowed for massive cost cuts. However, unlike many banking rivals, Bank of America has spent the last six years trying to build a permanently leaner corporate culture, as seen with management’s ongoing $3.3 billion in annual cost savings the bank is targeting by the end of 2018.
Even more importantly, after the trauma the entire banking industry experienced in 2008, Bank of America has focused on creating a fortress-like balance sheet, one strong enough to withstand an economic shock even worse than the Great Recession.
As you can see, Bank of America’s Basel III common equity Tier 1 capital ratio (the most conservative form of comparing a company’s working capital to its risk weighted assets) has been steadily climbing over the years. In fact, since 2010, under Moynihan’s leadership the ratio has risen 55.2% from 7.6% (very weak balance sheet) to 11.8%.
Source: Bank of America Earnings Presentation
Current Federal regulations dictate a minimum of 8% to ensure a bank can remain solvent (and avoid needing a federal bailout) even during an economic shock. In order for a bank to be allowed to return capital to shareholders via buybacks and dividends, a bank needs to prove that doing so won’t result in its reserve capital being too weak to survive a worst case economic scenario.
The scenario that was tested most recently modeled a far more severe and prolonged recession than what we experienced in 2008-2009 (when GDP declined peak to trough by just 5.3% and unemployment peaked at 10.0%).
Bank of America passed this year’s stress test with flying colors. In fact, the bank even managed to meet the minimum 8.0% CET1 ratio minimum, which indicates that it could have continued to pay its current dividend during the hypothetical economic turmoil.
In other words, management deserves a lot of credit for managing to turn one of America’s shakiest and unwieldy banks into a company that can likely stand up to a potential mini-depression without government support.
That’s thanks to the most important changes that Mr. Moynihan has brought to Bank of America, a relentless focus on high credit quality and disciplined loan underwriting.
Bank Of America has been steadily growing its loan book while maintaining strict credit quality (as seen with its declining net charge-off ratio below) rather than attempting to grab faster growth via extending credit to subprime borrowers shows that management is serious about transforming the corporate culture at the company.
In fact, UBS (UBS) analyst Brennan Hawken recently stated after its most recent earnings results that Bank of America was fast becoming “the most conservative large bank.” While Mr. Hawken believes that this pivot to ultra conservative banking could leave a lot of profit on the table, personally as a long-term dividend growth investors I applaud Bank Of America for attempting to mimic Wells Fargo (WFC) and JPMorgan Chase (JPM) in growing long-term shareholder value the right way – slow and steady.
This is especially true when you look at the bank’s exceptional growth in this time of severely low interest rates, which makes it hard for banks to earn substantial returns on their loans.
When it comes to all the metrics that matter for long-term investors, including EPS growth, the dividend payout ratio, the dividend itself, the efficiency ratio (what proportion of revenue go to operating the bank), the Tier 1 capital ratio, and net interest margin, Bank of America is making good progress (see table below).
This is especially visible in its growth in book value per share, which is the best objective measure for a bank’s intrinsic value. Specifically, the company has been steadily growing its book value despite the challenging market conditions in the banking industry, and thus setting itself up for potentially much stronger capital gains going forward (when its P/TBV multiple might expand).
Source: Bank of America Earnings Release
While there seem to be some reasons to be cautiously optimistic about Bank of America’s long-term growth prospects, there are two main risks investors need to keep in mind.
First, Bank of America’s non-performing commercial loan ratio has been rising in recent quarters. While this hasn’t yet shown up in its net charge off ratio, it could be a troubling sign that the credit cycle is turning.
Specifically, recent changes in U.S. regulations pertaining to money market funds that went into effect October 14th have caused the short-term LIBOR, or London Interbank Offer Rate, to rise sharply in recent months.
The new regulations are designed to safeguard money market funds by raising liquidity requirements for these short-term investment funds, which make up the backbone of the massive commercial paper market.
Commercial paper are short-term (270 days or less), unsecured loans that make up the oil that greases the corporate world. Companies tap this market to ensure adequate liquidity to pay customers, as well as employees. So the concern is that this increase in LIBOR will result in a contraction (i.e. higher borrowing costs) that might hurt companies and threaten the still weak economic recovery.
That’s especially true now that interest rates are rising in anticipation of a Trump administration stimulus plan, which could combine large increases in infrastructure spending, as well as tax cuts and deregulation. Basically, these factors could spur short-term economic growth at a time when the labor market is close to full employment, resulting in higher wages (great news for consumers) but also potentially higher inflation.
That in turn could force the Federal Reserve to increase interest rates faster than it had planned, which could potentially bring about the next recession. While higher interest rates generally improve the profitability of banks’ lending operations, a recession wreaks havoc as customers struggle to repay their loans.
This brings me to the second major risk, which is the rumored roll-back of certain provisions of the Dodd-Frank regulations passed after the financial crisis. While we have yet to see any specifics, rumors are that we could see lower capital requirements (allowing banks to move cash from low risk, low yield treasuries to higher risk, higher-yielding loans), as well as end the Fed’s annual review of a bank’s capital plans, including how much profit can be returned to shareholders as buybacks and dividends.
Don’t get me wrong, I’m not saying that should such regulatory changes happen that Bank of America would suddenly revert back to its highly speculative and dangerous gambling ways of the past. After all, management has gone to great lengths to raise its capital ratios far above the regulatory minimums in the name of maximizing the safety of the bank’s shares.
However, in the event that Mr. Moynihan was to retire, my concern would be whether or not the conservative changes he made at this world spanning bank would stick. It’s always possible that rising complacency among short-term investors calling for faster earnings growth and faster capital returns could lead a new management team to potentially weaken the bank’s balance sheet to “just good enough to survive another downturn.”
If the financial crisis proved anything, it’s that erring on the side of caution is always best. After all, the history of banking and investment management has shown us that models can easily fail, and that “once in a century” or even “impossible” events can occur with frighteningly high frequency.
Dividend Safety Analysis: Bank of America
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.
Bank of America has a Dividend Safety Score of 49, suggesting that the company’s dividend is reasonably secure and about as safe as the average dividend stock in the market.
How is it that a bank with such a strong balance sheet and low payout ratio has merely average dividend security? The answer lies in the nature of the banking industry itself.
As you can see, bank earnings can be highly cyclical thanks to periodic financial crashes that can result in massive earnings per share collapses. In the case of Bank of America, this can be even more extreme, with the bank swinging from earnings per share swinging from $3.29 in 2007 to a loss of -$0.37 in 2010.
Source: Motley Fool
This kind of extreme profit swings, combined with constant regulatory risks (such as calls to break up big banks), as well as having to OK dividends with regulators, means that banking dividend safety isn’t as cut and dry as merely looking at a bank’s payout ratio.
Remember that the business model of a bank is to have a highly levered balance sheet (even with today’s fortress-like balance sheet), which means that during an economic downturn losses can be magnified and force a bank to cut its dividend even if the payout remains technically sustainable.
We saw this in 2008-2009 when regulators forced Wells Fargo and JPMorgan Chase, who sailed through the financial crisis intact and still profitable, to cut their dividends “just in case” the cash might be needed had the economic collapse proven worse than it did.
Dividend Growth Analysis
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Bank of America has a Dividend Growth Score of 44, indicating potential for solid dividend growth going forward, but also serving as a reminder that the banking industry can be extremely volatile and even the safest banks can sometimes have to cut their dividends.
For example, while Bank of America’s immense improvements to its business model, balance sheet safety, and profitability over the past six years have resulted in impressive dividend growth, including its most recent 50% payout hike, the fact is that we still don’t know how the bank will fare when the next economic downturn hits.
That’s not to say that a recession is necessarily imminent. In fact, based on the most recent economic data, the Atlanta Federal Reserve’s GDPNow model is forecasting brisk 3.6% Q3 economic growth.
If this model proves accurate and U.S. economic growth does improve in the coming quarters, then the Federal Reserve will likely raise interest rates. Which combined with the already strong increase in long-term rates (as represented by rising 10 and 30 year US Treasury rates), could spell a bonanza for Bank Of America.
After all, of all the big U.S. banks it’s most set to profit from even minor increases in rates. For example, if interest rates rise by just 1%, Bank of America projects that its annual profit would soar by almost $7.5 billion.
Or to put it another way, if the Federal Reserve’s long-term forecast for interest rates is correct (2.5% increase by 2020), Bank of America is poised to potentially see its annual profits soar by $18.7 billion; a 118% increase compared to 2015. And that’s just assuming the bank’s current assets stay the same. In reality, a scenario in which interest rates rise steadily for years would likely mean strong economic growth that would see the bank’s assets grow substantially as well.
Since the bank has been aggressively buying back shares and plans to only accelerate share reductions going forward, the growth in EPS would be even more impressive. Which in turn could theoretically drive the payout ratio to even low levels based on today’s dividend and allow for some of the best dividend growth in corporate America over the next five years, potentially along the order of 15% to 20% per year.
Of course, this all assumes that the economy continues to recover and interest rates continue to rise. Since no one can accurately predict either factor, Bank of America’s potential to become of America’s best dividend growth stocks remains highly speculative.
When it comes to bank valuations, price to tangible book value (i.e. “liquidation value”) is the gold standard metric to use. That’s because this compares the current valuation to the objective intrinsic value of the bank, and by comparing this metric to its historic norm, as well as those of its peers, we can get a sense for the quality of the bank itself.
|Bank||Price/Tangible Book Value||13-year Median P/TBV||% Of Global Banks With Lower P/TBV|
|Bank Of America||1.19||2.59||51%|
For example, Wells Fargo and JPMorgan Chase have by far the best long-term track records of consistent profits and long-term shareholder value creation. Not surprisingly we find them trading at substantial premiums to Bank of America and Citigroup (C), which avoided bankruptcy only with substantial government help and massive dilutionary recapitalization.
Of course, since the election all financial stocks have benefited from a sharp rise in long-term interest rates. However, as you can see from the median P/TBV of these banks, they still trade at substantial discounts to their long-term median multiples.
In other words, as far as Bank of America is concerned, it’s not yet up to the quality standards of JPMorgan Chase or Wells Fargo, but it is making solid improvements and could represent an interesting investment opportunity, even despite the stock’s recent 19% rally since November 8th.
While I am very impressed with Bank of America’s turnaround under Brian Moynihan, the fact remains that the bank is still a high-risk stock if only because we have yet to see how the bank’s financials hold up under an economic downturn.
Management’s emphasis on solid conservative, core banking principles, a more diversified business model, and slow but steady growth make Bank of America a potentially alluring dividend growth stock as long as you understand the risks involved.
For long-term, risk tolerant investors, Bank of America represents an intriguing deep value, dividend growth investment; especially now if interest rates finally be headed higher. Just remember that if you do decide to buy a stake in this bank turnaround story, that you do so as part of a well-diversified dividend portfolio.
I personally don’t have the risk tolerance to hold a company such as Bank of America and will stick to proven blue chips, such as Dividend Aristocrats, that fall within my circle of competence. Bank stocks are complex investments, and their high financial leverage is a powerful force that cuts both ways.