Few investors will ever forget the terror of the financial crisis of 2008-2009, when the global financial system was on the verge of complete collapse and many people were convinced we were headed for another depression.
Shareholders of U.S. megabanks such as Bank of America (BAC) were especially brutalized, when one of America’s largest banks came within a stone’s throw of complete insolvency and saw its shares fall over 90% from their all-time high.
Understandably, large banks have been incredibly out of favor since then, despite what has been one of the more impressive turnarounds in corporate America. In fact, Bank of America’s efforts allowed it to raise its dividend by 50% earlier this year, and more payout growth could be ahead. Warren Buffett owns a number of banks in his dividend portfolio as well.
Let’s take a look at just how far Bank of America has come since the dark days of the Great Recession and if its shares might represent a solid, if still high-risk, long-term opportunity for dividend growth investors.
Founded in 1874 and headquartered in Charlotte, North Carolina, Bank of America, with almost $2.2 trillion in total assets, is the world’s 9th largest bank and the 2nd largest U.S. megabank.
It primarily operates in four main business segments but with two thirds of net income coming from its core consumer and corporate banking divisions:
- Consumer Banking: providing retail banking services such as checking, savings, and money market accounts, as well as credit and debit cards through its 4,700 banking centers and 16,000 ATMs.
- Global Wealth & Investment Management: wealth management, brokerage, and retirement services.
- Global Banking: commercial, and real estate loans, revolving credit facilities, merger & acquisition consulting, debt, and equity underwriting
- Global Markets: market maker on numerous global exchanges, risk management, securities clearing, settlement, and custodial services, treasury bonds (helps US government sell freshly issued debt), and mortgage based securities
|Business Segment||Q3 2016 Net Income||% Of Net Income|
|Consumer Banking||$1.813 billion||36.6%|
|Global Wealth & Investment Management||$697 million||14.1%|
|Global Banking||$1.553 billion||31.3%|
|Global Markets||$1.074 billion||21.7%|
Source: Bank of America Earnings Presentation
When current CEO Brian Moynihan took over in 2010, Bank of America was a catastrophe. Under previous CEO Ken Lewis, the bank acquired both Countrywide Financial (the home mortgage originator) and Merrill Lynch; two decisions that Morningstar’s senior banking analyst Jim Senegal dubbed “some of the worst capital allocations decisions of all time”.
Mr. Senegal isn’t being hyperbolic, as Countrywide and Merrill Lynch ended up exposing Bank of America to over $200 billion in legal fines, compliance fees, and enough exposure to toxic debt that it nearly bankrupted the company.
Fortunately, Brian Moynihan is a completely different banker than Ken Lewis (who was a huge fan of risky speculation in highly leveraged mortgage backed security derivatives and credit default swaps), who has spent his tenure laser focused on creating a far more conservative banking culture.
This can be seen through three major initiatives:
First, Moynihan sold off much of the bank’s underperforming business segments to focus on the bank’s core businesses, which allowed for massive cost cuts. However, unlike many banking rivals, Bank of America has spent the last six years trying to build a permanently leaner corporate culture, as seen with management’s ongoing $3.3 billion in annual cost savings the bank is targeting by the end of 2018.
Even more importantly, after the trauma the entire banking industry experienced in 2008, Bank of America has focused on creating a fortress-like balance sheet, one strong enough to withstand an economic shock even worse than the Great Recession.
As you can see, Bank of America’s Basel III common equity Tier 1 capital ratio (the most conservative form of comparing a company’s working capital to its risk weighted assets) has been steadily climbing over the years. In fact, since 2010, under Moynihan’s leadership the ratio has risen 55.2% from 7.6% (very weak balance sheet) to 11.8%.
Source: Bank of America Earnings Presentation
Current Federal regulations dictate a minimum of 8% to ensure a bank can remain solvent (and avoid needing a federal bailout) even during an economic shock. In order for a bank to be allowed to return capital to shareholders via buybacks and dividends, a bank needs to prove that doing so won’t result in its reserve capital being too weak to survive a worst case economic scenario.
The scenario that was tested most recently modeled a far more severe and prolonged recession than what we experienced in 2008-2009 (when GDP declined peak to trough by just 5.3% and unemployment peaked at 10.0%).
Bank of America passed this year’s stress test with flying colors. In fact, the bank even managed to meet the minimum 8.0% CET1 ratio minimum, which indicates that it could have continued to pay its current dividend during the hypothetical economic turmoil.
In other words, management deserves a lot of credit for managing to turn one of America’s shakiest and unwieldy banks into a company that can likely stand up to a potential mini-depression without government support.
That’s thanks to the most important changes that Mr. Moynihan has brought to Bank of America, a relentless focus on high credit quality and disciplined loan underwriting.
Bank Of America has been steadily growing its loan book while maintaining strict credit quality (as seen with its declining net charge-off ratio below) rather than attempting to grab faster growth via extending credit to subprime borrowers shows that management is serious about transforming the corporate culture at the company.
In fact, UBS (UBS) analyst Brennan Hawken recently stated after its most recent earnings results that Bank of America was fast becoming “the most conservative large bank.” While Mr. Hawken believes that this pivot to ultra conservative banking could leave a lot of profit on the table, personally as a long-term dividend growth investors I applaud Bank Of America for attempting to mimic Wells Fargo (WFC) and JPMorgan Chase (JPM) in growing long-term shareholder value the right way – slow and steady.
This is especially true when you look at the bank’s exceptional growth in this time of severely low interest rates, which makes it hard for banks to earn substantial returns on their loans.
When it comes to all the metrics that matter for long-term investors, including EPS growth, the dividend payout ratio, the dividend itself, the efficiency ratio (what proportion of revenue go to operating the bank), the Tier 1 capital ratio, and net interest margin, Bank of America is making good progress (see table below).
This is especially visible in its growth in book value per share, which is the best objective measure for a bank’s intrinsic value. Specifically, the company has been steadily growing its book value despite the challenging market conditions in the banking industry, and thus setting itself up for potentially much stronger capital gains going forward (when its P/TBV multiple might expand).
Source: Bank of America Earnings Release
While there seem to be some reasons to be cautiously optimistic about Bank of America’s long-term growth prospects, there are two main