Bank of America (BAC) posted another great earnings report. The bank’s first-quarter income of $6.9 billion or $0.62 per share was up substantially vs. $5.3 billion or $0.45 a year ago. Revenue of $23.1 billion was up from $22.2 billion. Below are the highlights from the company’s Q1 2018.
The reason banks hardly moved on earnings was the fact analysts were expecting larger loan growth than what was generally reported by the banks. This was not the case with Bank of America.
Furthermore, the primary thesis behind this pick is the dividend growth opportunity coupled with the potential for substantial capital gains. I have been pounding the table on the stock for the last five years. I wrote an article January of 2012 titled “The Time Is Now To Buy Bank Of America” when the stock was trading for $6.84.
So, I’m up substantially on this name in my personal portfolio, but feel the stock has much more room to run.
I see another great five-year period ahead for the stock. The stock looks technically solid here. The stock bounced off support and is now consolidating above it prior to the next leg higher, I surmise. The primary catalyst for the stock over the next five years will be prospects for substantial dividend growth. Even so, a major positive paradigm shift has occurred for the banking sector.
Banking Sector Paradigm Shift
A massive paradigm shift has occurred in the banking sector. A fundamental change in approach to regulations by Washington coupled with the Fed newly minted hawkish stance has created the perfect environment for Bank of America to flourish. On top of this, legal woes for the bank are now clearly in the past. The market backdrop for banks has turned notably positive due to the following four factors.
Four Major Bank Catalysts
- Rising interest rates – Banks make more money on loans in rising interest rate environments.
- Corporate tax cuts – The banking sector is the most highly taxed sector. Therefore, banks should benefit greatly from the recent corporate tax reforms.
- Increased volatility – The trading arm of banks tend to be more profitable during times of market volatility.
- Regulatory reform – Banks are the most highly regulated of the sectors. Trump’s regulatory reforms should help the banks greatly in the coming years. I see this as the tip of the iceberg. The 10-2 Year Treasury Yield Spread is currently at 0.483%, compared to 1.08% last year.
This is substantially lower than the long-term average of 0.97%. The curve is currently the flattest it’s been in years. The thing is, I think things are about to change. I expect the spread to increase as the Fed continues to raise rates and unwind the balance sheet. Furthermore, the spread is currently approximately 100% below the long-term average. I expect it may snap back some simply due to a reversion to mean. The yield spread widened by nearly 10% on Thursday. Another key catalyst for the stock is the dividend growth story.
Dividend growth story just starting
In 2017, Bank of America reported $18 billion in after-tax net income. Excluding the Tax Act impact of $2.9 billion, Bank of America would have reported net income of $21 billion. This reflects an 18% increase over an outstanding 2016 performance. The 18% increase represents the highest earnings run rate for the bank in its history. I expect this trend to continue. This should bode very well for the dividend growth story. Brian Moynihan stated on the previous conference call:
“Shareholders not only saw a share price improvement, but we increased our dividend by 60% and reduced our fully diluted share count during the year by 3.4%. Average diluted shares were down 370 million from this time last year and down nearly 1 billion from the peak. With an improved CCAR plus our additional 5 billion we’ll continue to make progress in this area.”
I have no doubt Bank of America will continue the progress in this area. Now let’s take a look at what Bank of America returned to shareholders the last time we were under similar conditions.
Dividend history review
The company paid a quarterly dividend of $0.64 prior to the 2008 housing debacle. This amounted to a yield of 5% prior to the dividend being cut. I expect the Fed to allow Bank of America to continue to return much more capital to shareholders based on solid regulatory capital levels.
In 2008, regulations were too loose and bad things happened. After the debacle, regulations overly tightened, substantially restricting the bank’s ability to make money. Fortunately, the regulatory pendulum has begun to swing back in the other direction. This is extremely beneficial for Bank of America. Lenders just recently lowered requirements for home loans. The sub-prime loan is back under a different name though. It’s now referred to as a “non-prime” loan. You can read the full story here.
The Bottom Line
The combination of Trump’s regulatory reform, tax relief, infrastructure bill, rising rate environment, and a robust U.S. economy should allow Bank of America to substantially increase the dividend over the next five years. I posit this will, in turn, drive the stock higher creating substantial capital appreciation as well.
What’s more, the stock is currently trading for much less on both a relative and historical valuation basis. The bank has a long way to go before getting back to its historical averages. Yet, that is what makes it such a great buy right now. Sure the bank has rallied hard in the last few quarters. Nonetheless, Bank of America did not participate in the enormous run the stock market has had over the last 10 years.
Most stocks are trading at or near their all-time highs. This makes finding bargains buys all that much harder. I say Bank of America is still a bargain basement buy even after its tremendous run. The stock has a PEG ratio of less than 1 and the lowest of the big money center banks.
The PEG ratio is a widely accepted indicator of a stock’s prospective value. It is favored by many analysts over the price/earnings ratio for the reason that it also accounts for growth. Similar to the P/E ratio, a lower PEG means that the stock is more undervalued. A PEG of 1 or less is believed to be promising. As Warren Buffett would say, “Price is what you pay, value is what you get.” Furthermore, the stock is still trading for less than two times tangible book value which is the historical average for the bank as well.
There’s one caveat regarding the use of the PEG ratio though, and it’s a big one: You need to perform additional due diligence and determine if the projected growth of the company is from healthy growth sources such as organic growth vs. growth by acquisition or stock buybacks, which are not necessarily bad, but may be unsustainable. Bank of America’s long-term growth story is solid in this regard.
On top of this, the dividend growth story should spur the stock higher for years to come. The banks will lead the markets higher into year end. My 12- month price target is $36. Taking the current 1.83% dividend yield into consideration implies a 22% total return opportunity along with significant growth prospects for the long-term investor. Those are my thoughts on the matter. I look forward to reading yours.
Disclosure: I am/we are long BAC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.