On February 9th, 2016, I wrote the article: “Bank of America Stock: Getting Dirt Cheap” in which I argued:
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.
What caught my attention at the time is that it was making $17 billion in net profits while only being valued at $160 billion. I thought this made the stock quite cheap. It remained unfashionable for a while because the dividend payment was so low at only 15% of profits. People buying Bank of America only got a 1% starting dividend yield, and had to deal with a five-year track record of near perpetual mortgage settlements.
Yet, the stock has now risen 91% this year. It is one of the top five performers in the entire S&P 500. When I read specific commentary about the bank as an investment, many investors ranged from hostile to tepid in their attitudes towards the bank.
The thought process could be summed up as: “It traded at $19 in 2010. It trades at $16 in the start of 2016. Why won’t it go up? Why won’t the mortgage settlements stop? This stock is dead money!”
I didn’t share that view because I saw the profits keep improving. When it traded at $19 in 2010, it was earning a penny per share in profit. The mortgage settlements consumed all of the bank’s potential profits. Between 2014 and 2015, there was a shift. The mortgage settlement litigation still ate into profits, but the issue was shifting to the periphery–earnings of $0.36 in 2014 had grown to $1.31 in 2015. By 2016, the earnings rose to $1.48. Furthermore, the possibility of raising rates would add billions in profits to the net income ledger.
While the stock price languished, the profits were growing and growing. That is a great place to be as an investor because an extended streak of earnings growth eclipsing stock price growth is one of the greatest indicators of significant capital gains ahead.
There are a lot of people out there who use trailing three, five, and ten year returns as a basis for investment, thinking that the excellent recent performers will be excellent future performers and the poor stocks in the recent past will remain so. Anytime you evaluate a stock in light of performance, you have to be focused on the earnings side of the equation.
With Bank of America, the earnings kept growing while the stock price remained stagnant. Heck, it was trading at $16 compared to $24 in book value. Now that the stock has shot up to $23, that discount is gone. My love affair with Bank of America as a “buy, buy, buy” has ended this month because future returns will mimic business performance. You don’t get that big boost from justified valuation expansion anymore.
The good news is that this story plays out over and over again in the stock market. I see people lamenting Gilead Sciences because its stock price has gone from $125 to $73 in the past two years. They use that price change as “proof” that it is a bad stock. I don’t see it that way–it’s a coiling spring, just like Bank of America had been these past few years. The P/E ratio for the stock is 6. That is not sustainable. This is an example of pessimism creating an attractive valuation.
A word on timing. Although I called Bank of America dirt cheap in February 2016, that was not the first time I noticed that the stock was trading at a steep discount. I thought it was cheap in 2015, 2014, 2013, and I may have even covered it favorably in 2012. Don’t expect a stock’s undervaluation to cure itself overnight. It took three to four years for my initial observations about Bank of America to pay off in the eyes of Mr. Market. I can’t ever tell you the “when”, but I can offer you my best estimates about the “what.”