3 Reasons To Back Up The Truck On Bank Of America – Bank of America Corporation (NYSE:BAC)

It’s no secret that as far as big banks go, Bank of America (NYSE:BAC) is by far my favorite. That’s due to a number of factors, including CEO Brian Moynihan’s amazing corporate turnaround that has transformed this once-failed bank into a true SWAN or “sleep well at night” dividend growth stock.

BAC Total Return Price ChartBAC Total Return Price data by YCharts

However, what is most important going forward, especially after Bank of America’s strong rally since the presidential election, is the fact that Bank of America remains one of the most undervalued growth stories you can buy today.

Let’s take a look at three specific reasons why I own Bank of America and plan to continue buying more. More importantly, learn why you might want to do the same.

Growth Potential Is The Best Among All Of The Mega-Banks

Thanks to both a growing economy (resulting in slowly but steadily rising loans), as well as rising interest rates, Bank of America is enjoying not just solid top-line growth but phenomenal earnings growth as well.

That’s because BAC is the best positioned to take advantage of rising interest rates, which the Federal Reserve expects to rise by 2.25% by the end of 2019.

Why is Bank of America likely to turn into a profit-minting money machine in the coming years? Well, a main reason is that of the four mega-banks, it has the greatest source of low cost capital, specifically non-interest bearing accounts such as checking accounts.

Source: 10-Q, Motley Fool

This grants Bank of America the lowest overall yield on deposits of any of its peers.

And, while true that these deposit costs will rise in the coming years, due to the need to compete to win and maintain customer deposits, keep in mind that most banking customers are loath to switch banks due to the sticky nature of their accounts.

For example, if you have your paycheck set up on direct deposit and have linked numerous credit cards, subscriptions, and utility payments via autopay to a checking account with BAC, then you’re not very likely to go through the hassle of switching to a rival bank and having to redo all those financial connects just to gain a few basis points in interest.

Which means that BAC, as with all banks, will raise their interest yields much more slowly than rates rise in general. That means a wider net interest margin spread and far higher profits going forward.

Of course, while soaring profits are great for the stock price in the short to medium term, what I care about as a dividend growth investor is what this exponentially growing river of money means for capital returns to shareholders.

Capital Returns Are Just Getting Started

A bank can return cash to investors in two ways, buybacks and dividends. While, as a dividend growth investor, I naturally prefer the latter, buybacks, when done right, are also a major benefit to income investors.

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That’s because you can think of each share of stock as a kind of perpetual bond, one that has a permanent right to the bank’s future profits, but most importantly, the rising dividends.

In other words, a reduction in share count means the existing dividend costs less, thanks to the increase in EPS causing the payout ratio to fall. That in turn allows the bank to grow the dividend faster, for longer, and studies have shown that yield + long-term dividend growth is a good proxy for overall total returns.

BAC Shares Outstanding ChartBAC Shares Outstanding data by YCharts

As you can see, Bank of America has been among the most aggressive share repurchasers of its peer group in the last few years. The good news is that this shareholder-friendly return of capital is just getting started.

That’s because, under the Dodd-Frank banking regulations instituted after the financial crisis of 2008-2009, a large bank (greater than $50 billion in assets) can’t return cash to shareholders until its annual Comprehensive Capital Analysis and Review or CCAR is approved by the Federal Reserve. That in turn depends on the results of the annual stress test, which puts a bank’s balance sheet under immense stress modeled by a severe recession, one that is far harsher than experienced during the Great Recession.

This is to ensure that the largest banks, aka “Too Big To Fail” can withstand a worst case economic scenario without the need for another bailout.

Fortunately, Bank of America has done an amazing job on becoming one of the most conservative, and safest, big banks in America.

For example, above, you can see the result of the 2016 stress test, which showed how low a bank’s common tier 1 capital or CET1 would fall during a severe recession. Bank of America’s balance sheet actually held up better than Wells Fargo’s (NYSE:WFC) and U.S. Bancorp (NYSE:USB), which historically are considered among the two most conservative banks in the world.

Better yet? Bank of America’s fortress-like balance sheet is only growing stronger with time, which bodes well for the results of the upcoming (June of 2017) stress test and CCAR review. At that point, Bank of America will announce its plans for buybacks and dividend raises for the coming year.

In the past, Brian Moynihan has said that returning capital to shareholders is the bank’s number one priority and could eventually top out at $25 billion in annual buybacks and dividends. Given that in the past 12 months BAC has only returned $11.3 billion to shareholders, this means that the pace of buyback and dividend increases could more than double in the coming years, as the bank’s profitability increases to levels that make this feasible.

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Dividend Growth Potential Is Staggering

Sources: GuruFocus, Morningstar, FactSet Research, Fast Graphs, Multipl.com, Moneychimp.com

Company Yield TTM Payout Ratio 10 Year Projected Dividend Growth 10 Year Potential Annual Total Return
Bank of America 1.3% 18.4% 15% to 20% 16.3% to 21.3%
S&P 500 1.9% 39.5% 5.8% 9.1%

A lot of readers wonder why I bother even covering Bank of America, must less owning it or recommending it, given the very low current yield. However, remember that my focus is quality companies that are likely to grow their dividends over the next decade.

From this perspective, BAC, with its rock bottom payout ratio and stupendous earnings potential, is one of the most appealing dividend growth stories you can find today.

Better yet? Thanks to truly absurd valuations, the stock is one of the least risky you can buy today.

Sources: GuruFocus, Fast Graphs, Morningstar, Simply Safe Dividends

Price To Fair Value Long-Term Beta Risk Ratio Projected 10 Year Total Return Risk-Adjusted 10 Year Total Return
0.36 1.35 0.486 16.3% to 21.3% 33.5% to 43.8%

That’s based on what I call my “risk ratio”, which is the price to fair value (more on this in a minute) times the long-term beta, or volatility relative to the S&P 500. This ratio is my estimate for how risky a stock is relative to the S&P 500. In this case, BAC is about 51.4% less risky than the market, meaning that its risk-adjusted total return potential is among the highest of any stock I’ve ever seen.

This fact is why Bank of America is currently on my “buy more every quarter” list, because the valuation, despite the strong recent rally, remains absurdly low.

Bank Of America Is Selling Stupid Cheap

BAC Total Return Price ChartBAC Total Return Price data by YCharts

It’s understandable that many investors might think the easy money has been made in Bank of America, given the impressive, peer and market trouncing returns in the past year.

However, despite soaring over 56% in the past 12 months, Bank of America actually remains incredibly undervalued.

Source: GuruFocus

Company P/TBV Historical P/TBV Yield Historical Yield
Bank Of America 1.36 2.08 1.3% 1.0%
Industry Median 1.29 NA 2.7% NA

That’s because on the two most important valuation metrics, price to tangible book value, and yield, Bank of America remains well below its historical norms.

Sources: Morningstar, Fast Graphs, GuruFocus

TTM EPS 10 Year Projected EPS Growth Fair Value Estimate Growth Baked Into Current Share Price Margin Of Safety
$1.63 10% (conservative case) $48.31 -16.1% 53%
15% (likely case) $63.70 64%
20% (bullish case) $89.60 74%
25% (best case) $127.58 82%

Meanwhile from a long-term perspective, via a discounted cash flow or DCF analysis, BAC is also one of the most undervalued stocks you can buy today.

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No matter what you actually believe the bank’s future EPS growth will be, it’s fair to say that the growth that Wall Street is baking into the share price (a 78% decrease over the next decade to just $0.36/share) is ludicrous given the immense profit growth and accelerating buybacks we’re likely to see.

That creates one of the largest margins of safety you are likely to ever find and makes Bank of America a must own DGI investment.

Risks To Consider

There are two main risks to keep in mind before investing in Bank of America.

First is the fact that as a mega-bank, there is always going to be a large amount of regulatory risk. For example, breaking up the big banks via a return of Glass-Steagall is something that currently enjoys bipartisan support. That includes none other than former Goldman Sachs (NYSE:GS) executive and current Treasury Secretary Steven Mnuchin.

Then, there’s the white elephant in the room and the reason for BAC’s outrageously low valuation. That’s the fact that despite the annual stress tests that the bank is now passing with flying colors, Wall Street remains skeptical of how well Bank of America will truly perform during the next economic downturn, when loan defaults will rise and its EPS growth is likely to turn negative.

While I am very confident that Moynihan’s turnaround of the bank’s corporate culture is permanent and will allow BAC to easily weather the next economic storm, long-term investors are likely to be in for some massive future volatility when the next downturn hits.

Bottom Line: Bank Of America Is Now A Truly World Class Bank, But One That The Market Continues To Misprice

While BAC will surely face its share of challenges in the years ahead, the fact remains that its long-term earnings prospects remain brighter than ever, as do the prospects for massively increased cash returns to shareholders.

Combined with a fortress balance sheet, one of the best management teams in the business, and a mouth-watering valuation, this makes Bank of America a truly can’t miss dividend growth investing opportunity.

Disclosure: I am/we are long BAC, JPM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.