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The broad-based S&P 500 has had a topsy-turvy year, but it sits higher by 7% year-to-date when all is said and done. The same can't be said for the financial sector, which is among the years' worst performers. One of the headliners to that underperformance is U.S. banking giant Bank of America (NYSE: BAC), whose shares are down 7% year-to-date.
What's plagued the financials sector has primarily been the uncertainty tied to near-term Federal Reserve action. The Fed entered 2016 with a game plan designed to raise interest rates four times. However, this plan was thwarted by early year weakness in stocks and the U.S. economy, lumpiness in the May jobs report, and even Britain's decision to leave the European Union. Higher lending rates would allow banks' net interest margin to expand, thus a delay in raising rates has deflated near-term profit expectations for all banks, including Bank of America.
Seven reasons why Bank of America is the best bank money can buy
But, worrying about what the Fed has to say on a week-to-week basis is shortsighted of Wall Street and investors. If you dig below the surface on Bank of America, you're liable to find a number of reasons why it can head substantially higher over the long-term. Speaking as a long-term B of A shareholder, here are seven reasons why I believe it's the best bank stock money can buy.
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1. Interest rate normalization will dramatically boost profits
Arguably the biggest oversight by Wall Street and investors is that long-term interest rates are likely to rise. Since the U.S. economy tends to spend far more time growing than in contraction, it's only natural to expect the Fed to focus its efforts on keeping the U.S. economy from overheating and prices from inflating too quickly. While I have no exact timetable on when interest rates will normalize, the economics behind interest normalization are there.
How will this affect Bank of America? According to the company's first-quarter 10-Q filing, a 100-basis-point increase in both short- and long-term interest rates would yield approximately $6 billion in net income. According to Foolish banking specialist John Maxfield, that's around double (if not more) what Wells Fargoand JPMorgan Chasewould generate in added interest-based income based on a corresponding 100-basis point move in short- and long-term rates.
Based on its shares outstanding, we could be talking about a $0.57 bump in EPS simply from a 100-basis-point move in short-and long-term rates.
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2. Cost-cutting opportunities could improve margins
Cost-cutting isn't a long-term growth strategy, but it's certain helped take the edge off of low lending rates in the interim. In Bank of America's second-quarter report, we found that employment at the banking giant had fallen to about 210,000, which is down about 25% from when CEO Brian Moynihan took the helm in 2010. Looking ahead, Bank of America anticipates shedding another $5 billion in annual expenses by 2018, reducing its annual expenditures to an expected $53 billion.
One factor playing into B of A's reduced costs is that its legal expenses have become clearer. Bank of America and its shareholders can put the $61 billion-plus in settlements the bank paid to the Justice Department in the rearview mirror, allowing for more transparent year-over-year comparisons of its operations.
B of A has also done a stand-up job of simplifying its business model, which helps reduce costs. As an example, through the first quarter Bank of America had reduced the number of home loan products it offered from 136 at its peak to just 39. The more transparent and simplified the business, presumably the more B of A can save.
Finally, it doesn't hurt that the company's active mobile banking users rose 15% to 20.2 million during Q2 2016. Mobile banking users mean fewer trips to physical bank branches and lower costs for Bank of America.
3. Bread-and-butter loan and deposit growth
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Regardless of the bank in question, loan and deposit growth is the bread and butter of banking. Based on Bank of America's most recent results, the company is having little issue attracting new clients, either consumer or commercial, and growing its loan portfolio. Total deposits at the end of Q2 grew to $1.22 trillion, up $66.5 billion from the year-ago quarter, while total loans outstanding improved $22 billion to $903.2 billion.
Deposit growth was particularly strong in B of A's consumer banking segment, which saw a year-over-year increase of $45.3 billion. Loan growth during the quarterly was slightly skewed toward consumer banking as well, however $9.1 billion of total loan growth was derived from its global wealth and investment management operations. B of A also retained the No. 1 spot in market share for retail deposits during Q2.
4. It's well-capitalized
Banks are admittedly not the easiest businesses to analyze, and Bank of America is no exception to the rule. However, what can undeniably be said about B of A is that it's far better capitalized now than it's been at any point over the past decade.
Image source: Bank of America.
Tighter regulations imposed on the banking sector by federal regulators have pushed banks to bolster the amount of capital they keep on hand in case of a financial emergency. Based on its Q2 earnings release, Bank of America common equity tier 1 capital ratio was 10.6%, up 30 basis points from the sequential first quarter. In layman's terms, Bank of America appears well-positioned to survive a moderate-to-severe recession in the U.S economy.
Furthermore, Bank of America, along with the vast majority of its peers, passed the Federal Reserve's annual Comprehensive Capital Analysis and Review (CCAR) in June. This is added confirmation that B of A has taken the right steps to improve its balance sheet and put itself on track to survive the next economic downturn.
5. Its loan portfolio is more balanced than ever
As we examined a little over four months ago, one of the biggest transformations observed with Bank of America has been its efforts to balance its loan portfolio. Prior to the Great Recession, nearly two-thirds of Bank of America's loan portfolio had been skewed to the consumer market, with a number of those loans tied to home mortgages (and we all know how that story turned out). By the earlier part of this year, Bank of America had reduced its reliance on mortgages and dramatically boosted its emphasis on commercial loans, effectively bringing its loan portfolio near a 50-50 consumer-business balance.
Why is this important? When the next recession inevitably strikes, Bank of America will be far less likely to be derailed by weakness in one area of the economy.
6. Improved shareholder yield
One of the biggest beneficiaries of Bank of America's improved balance sheet, cost-cutting, and loan rebalancing are its shareholders. According to B of A's CFO commentary in its Q2 report, the company returned nearly $2 billion in capital to shareholders just during the quarter!
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As the company's financials have improved, the Fed has been more willing to allow Bank of America to return capital. In June, following the CCAR, Bank of America authorized a $5 billion share repurchase plan and announced a 50% increase in its quarterly dividend to $0.075 per share, or $0.30 annually. The increase in B of A's dividend boosts its payout to a nearly 2% yield, putting it almost on par with the average yield of the S&P 500. Remember, share repurchases help reduce the number of shares outstanding, which can have a positive impact on EPS and make a company's stock look even more attractive on a fundamental basis.
7. Arguably the most attractive valuation in banking
However, the most attractive component of Bank of America, and why it could offer the best bang for your buck, is the company's valuation. When B of A was producing massive quarterly losses derived from huge legal expenses, it made valuing the business very difficult. However, with the majority of those legal expenses now in the rearview mirror and its business far more simplified, it allows for investors to make more calculated decisions about its valuation.
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Based on the company's Q2 results, its tangible book value (TBV), one of the best methods of valuing banking stocks, increased by 11% year-over-year to $16.68. This means B of A is currently trading slightly below its TBV when, in many instances, its peers are valued between 1.3 and 2 times their TBV. Some discounting is applied given Bank of America's legal woes, but with the understanding that its legal expenses are now mostly in the past, it would seem logical that Bank of America would begin to close the gap between it and its peers.
On a forward earnings basis, Bank of America is valued at just 10 times next year's earnings and around eight times its fiscal 2018 forecasts. Remember, once those interest rate hikes begin to hit B of A's bottom-line, its profits will increase quickly.
As a longtime shareholder there's clearly some bias on my part. However, the data appears to speak for itself: Bank of America looks to be your best bang for the buck in banking.
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Sean Williamsowns shares of Bank of America, but has no material interest in any other companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.
The Motley Fool owns shares of and recommends Wells Fargo. It also has the following options: long October 2016 $50 calls on Wells Fargo, and recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.