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Profits across the bank industry are being suffocated by low interest rates and high regulatory and compliance costs. But history shows that these trends tend to be temporary. Right now, I think most bank stocks are a buy.
Waiting for higher rates
It's reasonable to assume that interest rates could soon be on the ascent. When that happens, a bank like Bank of America (NYSE: BAC) will earn billions more in revenue and income each year. And when that happens, the valuation on its stock is almost certain to rise as well.
Right now, Bank of America's stock trades for a 33% discount to its book value. Higher rates could easily make it trade for one times book value, implying a meaningful upside based on valuation alone.
This is why I think Bank of America's stock is a buy right now, as the only way investors can benefit from the boost to the bank's stock from higher rates is to get in before the Federal Reserve actually pulls the trigger and raises rates.
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The Fed could do this at its next meeting in November, though prediction markets give that only a 17% chance of happening. Fast-forward to its meeting in December, however, and things look more promising. Prediction markets give that a 53% chance of occurring.
There are, of course, a number of caveats that you, as an investor, should keep in mind before taking the plunge and buying Bank of America stock.
The first is that interest rates may, in fact, not increase anytime soon. They won't remain near 0% for the rest of human existence, but there's a lot of time between now and forever. And during that time, stock in Bank of America could underperform the broader market -- this is referred to as opportunity cost.
It's also possible that the North Carolina-based bank could find itself entangled in the same type of conduct that occurred at Wells Fargo (NYSE: WFC) from 2011 to 2015. Thousands of Wells Fargo employees opened millions of fake accounts for customers in an effort to artificially boost the bank's revenue and cross-sell ratio -- that is, the number of financial products and services that each Wells Fargo customer uses.
There's been no definitive evidence that Bank of America employees did the same thing, but it wouldn't be surprising. Media reports quoting frontline bankers at other major lenders claim the practice spread industrywide, just as did abusive overdraft fees, mortgage servicing practices, and credit card add-on products that charged customers but gave them nothing in return.
In Wells Fargo's case, the revelation caused its normally solid stock to lose 13% last month. It could fall further, as additional lawsuits and investigations unfold -- and the same thing could happen to any bank.
A final caveat is that, while the interest rate cycle could turn at any point over the next year or two, the same won't be true for the consistent uptick in regulatory and compliance costs, which weigh on banks' profits and thus stock valuations. This is especially the case in the wake of the Wells Fargo scandal, which has cast a fresh pall over the entire industry.
The nation's biggest banks will suffer the most from this, as regulators and lawmakers seem intent on solving the too-big-to-fail problem. Just recently, two of the Federal Reserve's top officials intimated that their objective is to make banks consider slimming down and simplifying their operations. This would entail shuttering or spinning off business lines, such as trading units.
That's obviously not good for Bank of America, Wells Fargo, or any other big bank. But at the same time, the possibility of this actually happening seems remote.
Yes, Bank of America faces risks -- but I'm hardly bearish on its stock. Just the opposite is true: It's one of my largest stock holdings.
There's risk to owning any stock. But right now I think the potential reward from investing in Bank of America, the second-cheapest large-cap bank stock in the market today, outweighs the risks.
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John Maxfield owns shares of Bank of America and Wells Fargo. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool has the following options: short October 2016 $50 calls on Wells Fargo. The Motley Fool recommends Bank of America.
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