It has been a volatile quarter for shareholders of Bank of America (NYSE:BAC). The stock price was performing pretty well in the past 4 years during which it outperformed the S&P 500 index (NYSEARCA:SPY). Then, the COVID-19 virus started impacting the market, and the stock price lost as much as 50% of its market value.
While the 50% correction in market value took place, the earnings of Bank of America have only been impacted to a certain degree. More specifically, we expect a (limited) increase in credit risk for the outstanding loan portfolio of BAC and an adverse impact of the lower interest rates.
In this article, we will anticipate the impact of the COVID-19 measures on the intrinsic value of BAC, and we will conclude the article with an investment proposal.
Recent Price Performance
BAC’s stock price has been rising quite consistently in the past 3 years, outperforming the S&P 500 index with 50% over the period from January 2016 – December 2019. While the bank was not the strongest major bank (this position goes to JPMorgan (NYSE:JPM)), the bank did deliver a solid return on investment for its shareholders.
The outperformance was turned into underperformance as the COVID-19 fears struck the stock market. Bank of America lost 24% during March 2020, while the stock market “only” lost 12%.
Measured from the high price of $35.7 (27 December 2019) to the low price of $17.95 (23 March 2020), the decline went as deep as -50%. As a long-time BAC stock observer, I can honestly admit I did not see this one coming.
Bank of America was not the only bank stock which was underperforming the stock market, all major bank stocks declined materially. The worst impact was for Wells Fargo (NYSE:WFC) and Citigroup (NYSE:C).
COVID-19 Impact on Major Banks
Why did bank stocks lose so much market value following the COVID-19 fears, compared with the stock market in general?
This can be explained by 2 reasons, in my opinion:
1) Lower interest rates: On 15 March 2020, the Federal Reserve announced it cuts its target interest rates to 0% in order to support the economy during the coronavirus outbreak. As most banks make the bulk of their income from earning interest on the loans they are lending to their customers, this plunge in interest rates will result in a plunge in interest rate income as well.
2) A general recession is expected by economists for the US economy as the coronavirus will have a direct impact on the business activity of most companies and on consumer spending. As I’m writing this article, current US Jobless Claims are topping 6.6 million following the corona lockdown measures (an unseen record in lost jobs). This anticipated decline in economic activity will have a direct impact on the number of loans and credits BAC will be able to sell.
Impact on Bank of America
On 15 January 2020, BAC announced its Q4 earnings for 2019, which were in line with the expectations:
- Book value rose strongly from $25.1 to $27.3
- Tangible book value rose strongly from $17.9 to $19.4
- EPS growth of 6% year over year
- Investment banking fees grew strongly with 9%
In order to summarize the book value and the earnings per share and the impact of the recent coronavirus, we can resume the results as follows:
Source: data from stockrow.com
As we can see from this table, the stock price correction strongly lowered the current pricing ratios of Bank of America, with a P/E ratio back in the single digits and P/B ratio below 1.
As the market valuation of BAC declines this strongly, we need to assess the impact of the coronavirus and a potential upcoming recession on their earnings figures.
1) Interest income impact: This is one of the main drivers behind BAC’s stock decline: The Federal Reserve has lowered the target interest rate, and hence, the interest income of BAC will decline. While we do agree this will have an effect on the total income of BAC, we anticipate the impact will be limited:
– The total income from interest for BAC is 53% of the total income in 2019. The other half comes from non-interest income activities.
Source: Bank of America corporate website
– The total impact of the falling federal funds rate will be limited for BAC. For example, from 2018 to 2019, the rate dropped with 75 basis points. Over the same period, the net interest income of BAC only declined with 17 basis points to 2.35%. While we do agree the lower interest rates will have an impact on the interest income of BAC, we estimate it will be to a limited extent.
2) Loan defaults: As loans are the major business driver of BAC, any adverse impact (e.g. an increase in defaults) will have a direct negative impact on their income. This was one of the major issues following the credit crisis of 2008. As companies started defaulting on their loans, it had a direct impact on all the layers of the economy. As most shops and businesses now have to close their business temporarily (following the lockdown measures), we can reasonably expect an increase in the default rate.
In order to mitigate the impact of these events, the US government has taken a number of measures:
- The Federal Reserve has just announced a $2.3 trillion program in order to provide loans to small and midsize businesses.
- Quantitative easing has restarted with the purchase of $500 billion in treasuries and $200 billion in mortgage-backed securities.
- The Fed encouraged banks to use their capital and liquidity buffers to lend, which are funds kept in reserve for tough times.
As these government measures will likely strengthen the US economy, we expect an increase in loan applications at the major US banks. Last week, BAC announced it has received more than 178,000 loan applications worth almost $33 billion. As we expect this number of loan applications to grow further in the near future, it will have a direct positive impact on the revenues of BAC.
In conclusion: Given the reactivity of the US government and the Federal Reserve to mitigate any adverse impact of a potential recession, we do think US banks and businesses will manage to go through this (temporary) market crisis without material long-term damage. It might take a while for the total business volume to pick up again and for the jobless claims to lower again. We think Bank of America is strongly positioned to go through this crisis.
At the moment of writing this article (9 April 2020), the current stock price of BAC is $24.8, which is 30% below the previous 52-week high price. For the S&P 500 stock index, this gap is only 17%.
With the current P/E ratio at 8.5, we expect the stock price will rise to the previous P/E levels (pre-corona) of 11-12, bringing the stock price back to the $31 level.
More recently, we have also seen the stock price of BAC rise strongly as the stock market, in general, started to rise. Since the beginning of April, BAC is up 16.5% as the stock market has increased by 8%.
Risks and Trade Proposal
A primary risk of currently buying common BAC stock is the correlation with the stock market in general. As BAC has moved in tandem with the stock index in a leveraged way, we would anticipate a decline in the stock price of BAC as the market would fall in general (likely in a leveraged fashion).
Under normal market circumstances, we would recommend purchasing call options in order to limit your capital outlay and benefit from a leveraged ROI, which is typically provided by stock options if the trade works out. As the current market conditions are rather volatile, and we are uncertain the stock will recover in the coming 3-6 months, we would recommend avoiding call options and simply purchase the common stocks. The current implied volatility of BAC is around the 70% level, while the realized historical volatility is “only” 48% (source: optionistics.com).
In order to mitigate the impact of these potential risks on your investment in BAC shares, we would recommend giving your investment plenty of time to overcome the current market decline. Once the storm has fully passed, we expect BAC to rise to its previous price levels of $30-32.
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.