Bank Of America Missed Where It Matters Most – Bank of America Corporation (NYSE:BAC)

What happened?

Bank of America (NYSE: BAC) just reported an earnings beat. The company reported EPS of $0.46, beating analyst estimates by $0.03. Revenue of $22.83 billion was up 7.3% year over year beating analyst estimates by $1.05 billion. Sounds great, so why the selloff? The price action in the stock left many scratching their heads. One of my favorite authors Quad Seven Capital stated he thought the stock’s reaction to the earnings beat was “mind-blowing and illogical.” I have a different take. The reaction to the earnings beat is justified based on the present state of affairs for the following reasons.

Net interest income drop

As my good friend Quad 7 stated, net interest income is up substantially year over year, yet was down sequentially on a quarter-over-quarter basis.

Source: seekingalpha.com

After rising 7% in the first quarter to $11.3 billion, net interest income was down slightly in the second quarter coming in at $11.2 billion. This was highly unexpected as the other banks reporting showed substantial increases to net interest income. The sequential drop in net interest income was explained away by the bank in a note on the earnings call slides.

Source: seekingalpha.com

CFO Paul Donofrio attributed the weakness to the sale of the bank’s credit card business in the United Kingdom. Donofrio stated “suppressed long-term interest rates and other transient factors” led to the shortfall. Nevertheless, Donofrio stated net interest income should be back on track in the third quarter. The next issue I see is earnings were essentially a “buy the rumor sell the news” event.

Buy the rumor, sell the news

The “buy the rumor, sell the news” phenomenon occurs all the time in the markets today. Investors buy up stocks based on what they believe will happen in a given earnings report, economic event or new product release (the rumor). After the event transpires or the report is released (the news), they dump their positions and the stock moves lower. These buy the rumor sell the news spectacles often apply to earnings being announced. It seems Bank of America’s shares may be experiencing this effect as we speak.

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What happens is the stock rallies into earnings. Bank of America shares have rallied 41% since the November election. The rally occurs because investors emboldened by the rumors their favorite stock – Bank of America in this case – is going to hit it out of the park in regards to exceeding earnings estimates. The buying prior to the earnings announcement runs the stock up leaving it vulnerable to profit taking once the actual earnings are reported. It’s just that simple. In fact, buyers came in and bought the dip prior to the day being over. The third issue was the banking sectors missed across the board in regards to trading revenues.

Trading revenue warning

Goldman Sachs (NYSE: GS) missed by a wide margin regarding its trading revenue. In fact, Goldman stated: “We need to do better after the worst quarter ever for trading faced challenges in the second quarter.”

Bank of America warned trading revenue would be under pressure as well. Excluding adjustments, sales and trading revenue fell 9% for the bank. This was primarily due to a 14% slide in the fixed income division.

President Trump’s pro-growth agenda in question

On the same day earnings were released, Trumpcare was put on the back burner by Congress. The fact that the Republicans have had seven years to get a bill together and now can’t come to consensus on an Obamacare replacement has many wondering if Trump can get any bill pushed through Congress. I believe this news coming out on the same day as Bank of America’s earnings lowered many investors’ expectations that Trump’s plans for a corporate tax cut and further deregulation may be in jeopardy. Nevertheless, I see any selloff as a buying opportunity.

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The bottom line

We did not expect Bank of America’s shares to spike on an earnings beat this quarter. Much of the good news was already priced in based on the bank recently passing the Fed’s stress test with flying colors. Market participants should look upon this as an opportunity to start a position in the stock. As I have stated many times previously, the primary driver of share price appreciation going forward will be the increased return of capital to shareholders in the form of share buybacks and dividend increases. As Brian Moynihan stated on the conference call:

“Through the first six months of 2017, we have more than doubled the amount of net share repurchase and dividends to shareholders compared to the first half of 2016. As a reminder, with successful CCAR results behind us, we announced plans on June 28 to deliver $17 billion in capital back to shareholders over the next 12 months through higher dividends and net share repurchases.”

I like the sound of that. I expect the stock to continue to climb substantially over the next 12 months. The rally will be underpinned by the return of capital to shareholders primarily. What’s more, if Trump’s pro-growth policies get approved, this will be a huge win for the bank that is currently not priced in.

I believe the risk/reward equation still favors long trades and would buy the dip. Nonetheless, always layer in to a full position over time to reduce risk. The market could see a significant selloff if some type of exogenous geopolitical event occurs. Those are my thoughts on the matter. I look forward to reading yours! Please use this information as a starting point for your own due diligence.

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Disclosure: I am/we are long BAC.

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.

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