There are many people who will never own a stock that has previously cut its dividend (especially if the dividend cut occurred during a period in which they owned the stock). I find that to be an unfortunate piece of investment baggage, but I also recognize the right of everyone to invest according to the light of their own lamps. But if you are interested in weeding out suboptimal behavior, you should come to recognize that dividend cuts can often be fertile soil for deep value investment opportunities and can serve as a great launching point for high future income growth if the reason for the dividend cut was a solvable problem.
This is the situation that occurs when study Bank of America. During the financial crisis and its aftermath, Bank of America saw its share count double, the dividend got slashed, and the litigation burden became so substantial that it put the megabank in the red during 2009 and 2010 and ate up a significant chunk of earnings during 2011 through 2014. Specifically, Bank of America reported earnings of -$.29 in 2009 and -$.37 in 2010. In 2011, Bank of America’s profit was a penny per share, it made $0.25 in 2012, $0.90 in 2013, and made $0.36 last year. With the exception of 2013, all of those numbers were influenced by the implosion of Countrywide Financial and the litigation that followed.
Now, Bank of America is in a position where the current dividend payout ratio is severely mismatched compared to the reported earnings power of the firm. As 2015 comes to a close, Bank of America should register $1.45 in profits per share. This is the first year truly free in the clear from the chaos of the past. It is the equivalent of $17 billion in profit. The $0.20 dividend currently accounts for $2 billion of those profits. This is a substantial gap–the mature banking industry typically has a long-term dividend payout ratio between 30% and 60%, suggesting that the bank has the current capacity to pay between $5.1 billion and $10.2 billion in annual dividends. If Bank of America paid out half of its earnings as dividends, the payout would jump from $0.20 per share to $0.725 per share. That would be a 4.2% dividend yield based on current prices.
It also stands to benefit substantially from higher interest rates. If interest climbs, you want to own firms like Charles Schwab and Bank of America which will see earnings fly upward in a hurry (and act as solid counterbalances in a portfolio as the profit growth from these firms will counteract the P/E contraction that generally occurs during moments when an interest rate hike exceeds expectations).
Bank of America specifically estimates that earnings will increase by $4.5 billion for every percentage point increase in the Fed interest rates. The announcement of a quarter point hike has already improved Bank of America’s 2016 expected profits by $1.12 billion, all else being equal. Bank profits, which over the past thirty years have been a product of a declining rate environment, stand to experience a significant tailwind in the coming years as net interest income will increase because loan rates will go up by a faster rate than any increases that the depositor base will receive.
This means that Bank of America shareholders stand to experience a very strong increase in dividend payments over the next five years. The company is currently retaining $15 billion in annual profits, and the artificially low payout ratio is being used to retire stock. Net interest income increases, a product of rising rates, will also help earnings increase. And plus, there is the growth in the loan portfolio itself that should help. The payout ratio is still quite low, and the next five years represent a period of glide in which the dividend payout will rise at a faster rate than the earnings.
Now, the caveat. Stick me in a confessional and ask: Tim, if you had to build a portfolio of only twenty stocks, would Bank of America make the list? You’d get a solemn and contrite no. Solemn because I would be violating my general commitment to only covering the highest quality firms, and contrite because of the fact that Bank of America is only worth considering since it is so much cheaper than the higher quality firms in the industry like Wells Fargo, M&T Bank, and US Bancorp (a strategy that Lynch, Munger, Buffett, and Yacktman repeatedly inveigh against).
But when I analyze the totality of information available, I cannot help but conclude that Bank of America has a bright five years ahead of it, and that is why I write favorably about it. The capital reserves are doubled what they were during the summer of 2007 before the financial crisis hit. The extended litigation payouts, the wreckage of the financial crisis, and the low current dividend has created an environment in which the $17 share price is well below the $22 per share book value of the bank. Before the financial crisis, Bank of America would regularly trade at 2x book value (and traded at 1.5x book value during the early 1990s and 1980s excluding the savings & loan crisis three-year period). The lingering prejudice, and the absence of dividend hikes to confirm the return to normalcy, has made the stock cheap even as it readies for an extended period of success.
Although you would never know it from the headlines, Bank of America is almost twice as profitable as The Coca-Cola Company. Coke makes $9 billion in profits, and Bank of America now makes $17 billion. Absent the Countrywide Financial acquisition, this would have been one of the greatest long-term stories in the history of banking. It has a thirty-year track record of delivering 6.3% annual returns, which is remarkable considering the permanent and substantial dilution that occurred in 2008-2009 when Bank of America raised capital at fire-sale prices to increase the share count from 4.4 billion to 8.6 billion. For people that bought before 2008, profits will always be half of what they would otherwise be had this dilution never happened. The fact that long-term holders still have doubled inflation, despite this period, speaks to the strength of this bank absent the monumental blunder of 2008-2009.
It doesn’t take a whole lot to go right for shareholders to do well. The valuation is low, well below book value. The dividend payout ratio is low, roughly ½ to ⅓ of the historical average. The quality of the bank is much improved from eight years ago. There is a substantial tailwind provided by rising interest rates. And it also has Merrill Lynch under the corporate umbrella, a brokerage jewel that may one day prove to be a lucrative spin-off. These facts provide a bright future, and the prejudice from days gone by has presented an attractive valuation.
Originally posted 2015-12-21 17:16:18.
