Banks, banks and more banks. Wells Fargo (WFC), Citibank (C), JPMorgan Chase (JPM), and Bank of America (BAC). The 4 big banks in the United States after all the collapses and mergers. They account for 35-40% of the total market share.
One bank we are interested in is Bank of America. A close second is Wells Fargo, but in this post we will focus on the former. Banks have been hated on and unloved for the past few years and rightly so. Along with all the news headlines and the issues in Europe, many investors are fearful of investing in banks, especially with all the short term volatility. With that said, we are very aware of the possible backlash from Europe but with our banks becoming profitable and well capitalized, we do not see it as a long term concern. It may cause large short term volatility in the stock price, but will have little impact on the long term profitability of our banks.
The biggest concern is the fear of Bank of America going under. That is the item we must address before we proceed. We start by looking at the balance sheet. Taking a look at a balance sheet gives you a quick overview of the assets, liabilties and equity in a company. Remember, assets – liabilities = equity and the equation can be moved around, as assets = liabilities + equity.
Currently Bank of America trades at around 7-8 dollars per share. With 10.8 billion shares outstanding, that is a market capitalization of ~82 billion.
Book value is a measure of how much the company is worth in tangible and intangible items. Such as goodwill and brand names, etc..etc.. Book value per share, is somewhere between 18-20/share for Bank of America. Tangible book value, meaning just physical/real assets that can be sold with a concrete value, is around 10-12 dollars a share. So assuming a worst case scenario where Bank of America becomes bankrupt and must liquidated, people would receive a minimum 10-12 dollars a share minus any litigation/debt outstanding, assuming all their intangible assets are worthless.
Bank of America currently trades at 7-8 dollars/share. That is a 25-45% margin of safety.
Home mortgages are generally bundled up, slapped with a coupon and then sold to the public. So say a RMBS, has 1,000 home mortgages packed together and is offering a coupon/interest rate of 4% to investors.
Mortgages usually have a high burn rate for the first few years and taper off over time. Meaning if we have a package (bond/RMBS) of 100,000 mortgages, we would have the majority of the defaults in the first few years and a drastically reduced amount in remaining life of the mortgages/bond. This seasoning, is normally caused by people who can’t pay their mortgage, usually default after a few years. People who can pay their mortgage, generally have no issues paying it for 30 years.
In our current situation, take all the 3/1 or 5/1 or even 7/1 ARMS (adjustable rate mortgages) that were sold to homeowners, a housing crash and a bad economy with high unemployment rates and you have an idea as to how unprofitable it was for banks, especially with lax underwriting of these loans/portfolios. But note that ARMs are generally 3/1 and 5/1 ARMs (artificially fixed at a low interest rate for 3 year or 5 year , then annually updated based on current interest rates). This means that over the course of 5 years, most of the defaults/refinances will occur. For us, the bad loans were funded starting in 03 and 04 and peaking in 06-07. It has been 5-7 years since then. This means that the majority of the defaults have already occured.
After the financial crisis, Bank of America and the industry as a whole, has become very strict in their lending practices. More than is probably necessary. But that is to be expected as a result of the financial crisis. The new loans they are writing are in house only to ensure their quality. This is leading to a profitable book of mortgages.
With all this said, chances of Bank of America going under are very slim. If they do go under, there is the protection from the margin of safety. If they do not go under, and continue to generate to repair their balance sheet and start earning 1-2 dollars a share profit in normalized profits, then you are looking at a 15-25% earnings per share for your 7-8 dollar stock price.
With a possible and plausible normalized earnings of 1.50+, trading at a P/E of 12-15 would net a stock price of 18-22.
The volatility of the stock works in our favor as a value investor. Markets tend to overreact and combined with daytrading and high frequency traders, allows us to find very favorable pricing.
One event that comes to mind is when AIG raised a lawsuit against Bank of America for 10 billion dollars. The instant market reaction was a drop of 20 billion in market cap. Meaning, just based on the fact that there is a lawsuit, not taking into account the chance of winning/losing the suit, the market automatically assumed, that it would lose, and somehow lose twice what the lawsuit amount was for. As we have faith in our analysis of the firm, the lower the price goes, the more we can buy and earn an even greater return.
In an efficient market. What should have happened is. 10 billion dollar lawsuit, chance of losing lawsuit 75%, chance of winning 25%, therefore a reduction of 7.5 billion in market price/share price should occur.
Disclaimer: Long BAC and WFC