We are removing Bank of America (BAC) from our Best Ideas list on the long side.
After being bearish on Bank of America throughout 2011, we first turned bullish on January 19, 2012 in a research note entitled "We're Getting Bullish on Bank of America". At that time the stock was trading at $6.96. Not quite the low of $5 set a few weeks earlier, but still pretty good.
We formally added BofA to our "Best Ideas" list on the long side when we first launched our Best Ideas list, on February 27, 2013. By then the stock was trading at $11.30. We've had it on the Best Ideas list since then and the stock is up roughly 48% since (and 140% since our early 2012 call). Meanwhile, the S&P 500 is up ~32% since 2/27/13 and ~52% since 1/19/12. On both an absolute and relative basis BAC has been a solid long-term performer. Normally we don't leave ideas on for a year and a half, but since the thesis was steadily playing out we saw no reason to change our view.
Waiting for Godot
So why now, after all this time, pull the plug? There a few reasons.
1. Earnings. Normalized earnings remain elusive years after the term first floated circa 2011/12. Recall that in 2011 the company earned one cent per share for the whole year. In 2012 BofA earned 25 cents per share. In 2013 things started looking better with 90 cents in full year earnings, but in the first half of this year the company stumbled, earning just 14 cents on a GAAP basis (28 cents, annualized). The bigger picture, however, is that most of the core metrics at BofA have been negatively trending for the last year and a half and seem to show no signs of inflection.
We profile these trends in the charts below for NIM, NII, non-interest income, non-interest expense, pre-tax pre-provision net income, pre-tax income, and EPS. The punchline is that revenue, both NII and non-interest income, have been in steady decline while operating expenses have been rising. The only bright spot has been provision expense trending lower, but with reserve release compressing, this too will reverse from tailwind to no-wind and then headwind even in a benign credit environment. In other words, it's hard to see how earnings power advances from the recent run rate of ~24 cents per quarter (average of last six quarters, excluding 1Q14 in which EPS was -$0.05) to the expected NTM rate of $0.34 when all the metrics are going the wrong way.
2. Macro. When we first turned bullish on BofA back in January, 2012 it was largely because we thought that (a) the company had ringfenced its mortgage liability and (b) the ECB's LTRO program would succeed in preventing Europe from sliding into the ocean. We were right on both accords as Article 77 kept the $8.5 billion settlement in place and Euribor-OIS receded back to the mid-teens bps. Several months later, it was rising home prices that became the new rallying call - a tailwind that persisted right through this Spring.
Today, however, housing is a receding tailwind as the rate of home price change has been decelerating for 4 straight months now and we expect that trend to continue. Further, while there are many "hotspots" of eco/geo risk around the world (China, Ukraine, etc) the global, US banks have priced in very little discount/risk. #Asymmetric.
3. Beta Renormalization. We added a new chapter to our bullish thesis on BAC back on March 7, 2013 when we published a note entitled "Long the Big Cap Beta Renormalization Trade". We argued that BAC, MS and C were undervalued on the basis of their capital position relative to their beta. We revisited the thesis on November 4, 2013 in our note "Banks: Capital & Volatility - A Look at the US & EU Banks With the Most Upside". At the time of the first note, BofA's 1-yr beta was just under 2. This compared with a Beta below 1 prior to the crisis, in spite of having materially increased its capital position over the ensuing time period. Our argument was simple: we though that beta would come down as the market realized risk was lower due to the permanently higher capital position. As beta came down, we argued, EVA would rise since beta is a key input in cost of capital. Finally, we have shown that EVA is very strongly correlated with price/tangible book multiples (stronger than ROE or ROTE alone). So we argued that as beta came down, the multiple to tangible book value would rise. That's exactly what happened.
Since our March 2013 note, BofA's beta has fallen to around 1.25 from just under 2. During that same period, the price/tangible book value multiple increased from 92% to 118%. This is a slightly smaller increase than we had originally postulated, but we think the framework worked well, overall.
The reason it's relevant today is that with beta back down to 1.25, this idea has largely run its course. Yes, there is likely some further reduction possible, but much of the move has already happened, as we show in the beta chart below. We also show the relative upside/downside to fair value for several of the larger banks based on our EVA fair value model. On that basis, we find that BofA is currently just about fairly valued.
Based on this, we think it makes sense to remove Bank of America from our Best Ideas list on the long side. Please bear with us as we look for a suitable candidate to replace it.
Joshua Steiner, CFA
Jonathan Casteleyn, CFA