To my knowledge, this hasn’t gotten any media attention, but it’s an interesting fact that the Wells Fargo loan portfolio currently has a higher nonpayment rate than the Bank of America loan portfolio. Wells Fargo isn’t collecting payments from 1.40% of its loan portfolio, and Bank of America isn’t collecting payments from 1.21% of its portfolio. I call it an interesting fact rather than important data point because things like interest rates across the portfolio and the amount of capital available have much greater weight in determining whether a bank stock is a sound candidate for investment, but I mention it because it is important to be aware of when the headlines do not match the actual numbers.
If you follow analysis of Wells Fargo stock and Bank of America stock, almost every analyst will conclude that Wells Fargo is a higher quality bank investment. While I agree with the conclusion, the gap between the current quality of Wells Fargo and the current quality of Bank of America has been understandably exaggerated.
The amount of share dilution, billion-dollar losses flowing from the Countrywide acquisition, and difficulty securing federal approval for dividend hikes have given Bank of America shares have an unacceptability bias even as the capital ratio has doubled, the amount of delinquencies has come down below the rate of even Wells Fargo, and profits have climbed. And this is all before the arrival of expected interest rate hikes, which will produce a substantial lift to Bank of America’s net interest income because rising interest rates enable lenders to raise the rates of loans at a faster rate than what they will pay to depositors with savings accounts at the bank.
Bank of America is expected to make $18 billion this year, and the bank itself is only valued at $141 billion for a P/E ratio of 7.8x this year’s earnings. Wells Fargo makes $21.5 billion in profits, and is valued at $246 billion or 11.4x this year’s earnings. If someone were planning on putting a large chunk of their net worth into a financial stock, or planning to hold the stock for 20+ years as part of a permanent portfolio, then I am firmly on board with the selection of Wells Fargo. The history, institutional controls, ability to grow the loan portfolio in a generally sound manner, dividend effect, and even the halo effect of other investors committing to Wells Fargo for the long run are persuasive.
But if your time horizon is shorter–say, you are looking out for the next five years–then I remain unconvinced that each dollar of Wells Fargo profit should be valued at a 46% premium compared to that at Bank of America. I’d put the Wells Fargo premium somewhere in the 15% to 25% range, based on the strides that Bank of America has taken to get to its current position of sound footing which is largely unrecognized due to 2008-2009 memories and Bank of America’s tardiness in getting the dividend growth back on track.
When I study Wells Fargo, I keep coming to the conclusion that it is worth somewhere in the $50s, which might suggest an immediate upside of nearly 15%. But when I run the numbers on Bank of America, I keep getting a fair value estimate somewhere in the low $20s. That’s a nearly 70% upside.
The current $0.20 dividend at Bank of America requires a payment of slightly over $2 billion. Meanwhile, Bank of America is going to make around $18 billion in net profits. That 11% payout ratio suggests a lot of room for future dividend growth as large banks tend to pay out somewhere between 30% and 55% of their overall profits as dividends to shareholders. I would have guessed that last year would have been the appropriate time for Bank of America to begin raising its payout above the $0.05 quarterly level, as it made $15.8 billion on the year. With the Countrywide-related settlements almost entirely behind it, the cash is pouring into Charlotte.
But the delay in the dividend hike has helped Bank of America repair its balance sheet faster than if the sharp dividend increases came last year. The $15, $18 billion profits are the residual claim that accrues to shareholders whether or not it is actually paid to them as cash in the form of dividends. The dividend delay enabled Bank of America to bolster its Tier 1 Capital Ratio to get on par with Wells Fargo for a Tier 1 ratio in the 10.25% to 10.50% range. At the beginning of 2014, Bank of America was at 9%. The retained earnings enabled Bank of America to achieve a 17% jump in capital that may have otherwise taken two to three years to achieve.
In my view, Bank of America shareholders are six or seven years away from collecting $1 per share in dividends, which would mean that each dollar invested today would be paying you $0.0769 annually in 2022. You would well paid for your patience, as significant capital gains will await those who hold the stock patiently through the company’s return to annual dividend growth. Heck, Bank of America could theoretically pay $1 per share now, as it would require Bank of America to pay out $10 billion of its $18 billion profits to shareholders for a payout ratio in the 55% range. It wouldn’t happen all at once, but the earnings capacity current exists to support such a payout ratio.
I am not sympathetic to the common investor argument that it is wise to wait and see a couple years of dividend increases before contemplating purchasing a stock like Bank of America. The reason why someone would consider Bank of America stock is because it is a value pick (if BAC currently traded at $22, and Wells Fargo traded at $40, it would be a no-brainer to buy and hold Wells Fargo without even considering Bank of America. But those aren’t the terms offered. It’s BAC in the $13 range or WFC in the $48 range, and the discount available on the BAC shares is just too much to ignore)
The reason why you wouldn’t want to wait for a rise in the price is that most of the capital appreciation will occur between the time that the uncertainty exists and the time that investors grow more confident about the company’s future. Waiting for a few years of dividend hikes may put you in a position to achieve total returns that are parallel to the subsequent business results of Bank of America rather than the subsequent business results of Bank of America + the transition from undervaluation to fair valuation. The latter strategy usually makes a lot more money (i.e. “you pay a high price for a cheery consensus”).
I find it quite interesting that Bank of America currently has loans that are better performing than the portfolio of Wells Fargo, and both banks now have the same Tier 1 Capital ratios. Bank of America is also slated to make $18 billion in net profits this year, while the current dividend plan only amounts for 10% of profits. This reality at Bank of America is very different from the daily stories you hear about Bank of America–the negative stories may be true, but they don’t stop Bank of America from making over $1.5 billion profits per month. The current quotation in 7-8x earnings range seems to suggest the possibility of a classic value investment pick.