Twenty-eight months into the bull market that started in March
of 2009, the S&P 500 has risen by 97%. Believe it or not-and
this might come as a surprise to some of you-the financial stocks
have actually participated in the rise! The S&P Financials are
up by 149% from their lows, while the KBW Bank Index is up by
Yet despite that outperformance, the financials don't have a lot
of fans among investors. Take a look at the holdings of the 25
largest U.S. equity mutual fund managers. Almost all of them are
underweight financials, particularly the banks. And more recently,
the financials and the banks have both lagged. The financials have
pulled back by 14% from their recent high while the banks are off
by 21%, compared to just a 4% pullback in the S&P 500.
I mention all this to provide some context for the view I've had
of the stock market (and the financials in particular) for some
time: the bull market in stocks still has a long way to run. Banks,
I believe, will be at the forefront.
In the last month, I've had the chance to sit down and talk
about the financials with two of the greatest investors of our
lifetime: Bill Miller of Legg Mason and Chris Davis at the Davis
Funds. Both are of course long-term, value investors-and both are
very positive on the group.
Let's focus on the banks, first. I've said for some time that
the bank stock bull market would have three legs. The first lasted
a year, and reflected investor recognition that the banking system
wasn't going to collapse, after all. The second, which we're in
now, would be driven by a return to normalized earnings and
valuations. The third leg of the rise will be driven by the
deployment of banks' excess capital.
As I say, we're in the middle of the second leg now. Sure
enough, the early second-quarter reports that have come out have
shown that the banking industry's earnings are recovering strongly,
as credit problems ease and economic activity picks up generally.
Yet earnings recovery or not, the valuations of many banks,
especially the ones that were most stressed by credit, haven't
expanded much from where they were at the depths of the crunch.
So the most attractive opportunity I see in the group today is
in what I'll call "credit-recovery" banks. These are the banks that
had severe credit issues that are being steadily fixed. My
favorites are companies in the $1 billion to $30 billion asset size
where we've done extensive work on credit, and have confidence that
recoveries are real and durable. Among our favorites (both of which
we own, by the way) are Citizens Republic (
) and Mercantile Bank (
). Both should report strong recovery earnings over the next two
weeks. What's more, in coming quarters they should recover huge
deferred tax assets, which will significantly boost their GAAP
tangible book values, as they demonstrate sustainable
Among the big banks, meanwhile, one name among our positions
deserves a mention: Bank of America (
). Longtime readers know that I haven't had a lot of good things to
say about BofA for, oh, the past 20 years or so. Even now, no one
will confuse BofA with a growth company. But the stock has gotten
hammered so badly that BofA's franchise is worth considerably more
than the company's current market value.
To see what I mean, take a look at one quick-and-dirty bank
valuation measure: market cap plus preferred as a percentage of
assets. Among the big banks, BofA is at the bottom of the heap:
On other standard valuation measures, BofA sticks out as well.
The stock trades at 5 times its normalized earnings, and 76% of its
tangible book value. There's no doubt, then, that investors aren't
optimistic about the company's long-term earnings outlook.
Those doubts notwithstanding, the fact is that the company faces
only one major-and well-known- problem: its credit and legal
exposure to future residential mortgage loan losses. I won't go
into a detailed discussion here of why I believe future losses from
litigation not already taken or reserved for are manageable
(they'll be under $10 billion I believe). But if you want to read
some great research on the topic, take a look at the work that's
been done by John McDonald of Sanford Bernstein.
If you can get comfortable with BofA's future residential
mortgage loan costs, the company has a lot of things going for it
that investors don't seem to be properly appreciating.
- Powerful pre-tax, pre-provision earnings. BofA currently
earns close to $40 billion a year pre-tax, pre-provision, and
pre-mortgage litigation costs. This is the fuel that will enable
the company to burn through future mortgage related
- BofA has already put aside huge reserves for mortgage losses
and related litigation costs. The company has a $ 40 billion loan
loss reserve and several billion dollars worth of litigation
reserves. The former is already coming down, and that will
continue for several quarters, which should in turn drive higher
earnings. The latter will come down when the end of the mortgage
mess is in sight.
- Credit is improving. Commercial and consumer credit,
ex-residential mortgage loans, is clearly getting better. This
trend should continue. Even mortgage delinquencies appear to have
- BofA's net interest margin is set to improve. No other bank I
know of has as high a percentage of its funding mix be long-term
debt. This debt should decline all year, which would help the
company's margin this year and next.
- Bank of America has an efficiency plan in place. After credit
improvement, BofA's highest priority is better cost
efficiency-and the company has put in place a major initiative to
achieve it. The positive impact from this effort will be seen in
BofA of course has some challenging longer-term problems. I am
not suggesting otherwise. What I am suggesting, though, is that the
negatives are well-reflected in the company's valuation, while the
positives (and there are more than a few) are not.
"So what's the catalyst?" for bank stocks overall, or Bank of
America in particular, investors will often ask. Usually I answer,
"Who knows?" It's hard enough to find attractive investment
opportunities. Predicting what will make them go up is impossible.
For value investors like Bill Miller and Chris Davis, the catalyst
is simply BofA's incredibly favorable risk/reward profile. Some day
down the road-who knows when?--some relatively insignificant event
will occur that will cause investor sentiment to slowly begin to
change, and BofA's valuation will at last start to edge higher.
Smart value investors don't wait for that unpredictable moment.
Banks vs. Tech
Investor sentiment toward the banks today versus the tech
companies reminds me of 1999. It's crazy! Either banks are
undervalued or certain tech stocks are overvalued, or both.
Let's take one example. Fifth Third (
) has a market cap of $11 billion, while LinkedIn (
) has a market cap of $10.4 billion. Fifth Third trades at 1.5
times its revenues, while LinkedIn trades at 43 times revenues.
When Fifth Third reports its earnings-yes, earnings--this week,
they'll be higher than the revenues LinkedIn is apt to generate for
the entire year! In fact, Fifth Third will pay out more cash in
dividends to shareholders this year than LinkedIn's revenues will
be for all of 2011!
Just like in 1999, the valuation disparities that exist today
between the banks and some tech companies (either public or
soon-to-be-public) likely are not sustainable. And just like in
1999, I can't tell you when the mismatch will end, but it will,
that's for certain. In the meantime, I like the investment
risk/reward tradeoff today much better owning bank stocks-even one
I haven't liked for decades, Bank of America.
Lowe's: Dividend Stock Analysis