Bank of America Stock: Getting Dirt Cheap

I know most people don’t like it when the price of stocks fall, but I find it provides clarity when searching profitable large-caps that are selling at obviously cheap valuations. Bank of America fell almost 5% in Monday’s trading as there have been increased fears over the commercial lending to upstream oil firms on the bank’s books.

Specifically, Bank of America disclosed that it would lose around $700 million from its upstream oil portfolio this year if oil stays around $30 per barrel through the third quarter of 2016. Bank of America is running a $890 billion loan portfolio, and $21 billion consists of loans to firms in the oil and natural gas exploration fields.

The stock is now at $12 per share, a price it saw back in 2010 when it was losing $2.2 billion per year. Now, the beaten down valuation of the stock is almost entirely a result of lingering prejudice from the financial crisis and investor hostility towards the current $0.20 annual dividend payment. I know that obliterated dividends are just about never popular with investors, but they do come with one important advantage. If a company sees its core earnings profile improve before it restores its dividend, then all of that capital goes towards improving the balance sheet rather than turning around and shipping it out to shareholders. It’s a nice tailwind that speeds up the recovery.

In 2015, Bank of America made $15.8 billion in annual profits. It only made $4.8 billion in 2014 profits because it had to pay out the large remaining chunks of legal settlements arising out of the Countrywide disaster during 2008 (I think a strong argument can be made that Bank of America’s acquisition of Countrywide was the worst acquisition for any American company of all time).

But now, the company’s profitability has finally been restored, the legal expenses have abated, and it is back to being a large bank. Yet, it’s only being valued at 9x earnings. The book value is around $23 per share–even if some oil defaults knock that value down to $21 or $22, that is still a significant discrepancy between the current $12 share price and the $20+ book value.

What catches my attention is that Bank of America is only paying a tiny bit above $2 billion in dividends while it is earning almost $16 billion in profits (and profits are estimated to approach $18 billion this year). Despite what the financial headlines, the low dividend, and the low stock price signal, this is an immensely profitable core engine that is selling at a steep discount.

Seven years from now, after Warren Buffett’s Berkshire Hathaway assumes ownership of 7% of the bank by exercising negotiated warrants at a $7.14 strike price, it would not surprise me to see the stock trade around $30 per share and pay out somewhere around $1 or more in dividends. Berkshire shareholders will be collecting 14% on this part of their Bank of America investment, and people that buy today will be collecting 8.3% in annual income compared to the amount of initial investment in 2016.

It seems to me that Bank of America is one of those stocks that brings out the irrationality among many of its owners. I understand it–in many respects, the dividend hikes have been long overdue, and the good news that seems destined to arrive has always been put off over and over again.

But in the immediate aftermath of the financial crisis, the question was when the earnings would return. That’s what the delay was all about–springback in earnings kept taking longer and longer to materialize. After losing $2.2 billion in 2010, it made $1.4 billion in 2011. Then it made $4.1 billion in 2012 after paying out large legal settlements related to Countrywide’s mortgage violations. When Bank of America grew its profits to $11.4 billion in 2013, people thought the tide turned for good, before encountering a final large round of legal settlements in 2014 that took profits down to $4.8 billion. Now, the earnings are finally in the clear at the $16 billion range, and I am reading all of this stuff about people throwing in the towel because the dividend hasn’t been raised and the stock price is still low.

That doesn’t make sense. The profits have exploded, the bank is retaining $14 billion, and it is probably going to take either (1) an interest rate hike; (2) a sustained period of 15+ billion annual profits; (3) a dividend hike; or (4) an activist investor to get the price above the $20 per share mark where it should be.

But when the earnings are so high relative to the price of the stock, why would you discard it now? This is the fun part–the rocket is about take off. Whether it happens quickly or takes a few years shouldn’t matter, as the magnitude of the waiting capital gains is so substantial that it is worth the opportunity cost of an extended delay for the market to price it accordingly.

The current trading in Bank of America stock shows the limitations of using dividend payments as a proxy for the current strength of the business, and it also speaks to the downside of reading financial news all the time if you let perceptions replace reality of what is going on at the company.

In some ways, Bank of America is cheaper now than it’s been at any time since 2012. It has all the litigation payments settled, the talks about the lending to the oil and gas upstream firms is overblown in that it doesn’t have a substantial effect on annual profits, and the current dividend of $0.20 compared to $1.31 in earnings is going to reward patient investors at some point when the rising dividend payouts come.

It also stands to benefit significantly from higher interest rates, which has become out of vogue to discuss at the moment but is still something that is likely to happen over the medium term (i.e. ten-year U.S. bonds ought to be yielding much more in 2021 than they are today). Bank of America is a $12 stock with a conservatively calculated book value over $20 per share. The dividend payments are only $2 billion compared to $16 billion in annual profits. 2016 profits are expected to be higher than 2015 profits. The bank is trading at 8.5x earnings. It makes $43 million in net profits per today, but the media coverage of the stock sure doesn’t act like it. Therein lies the opportunity.