Warren Buffett (Trades, Portfolio) is continuing to bet big on U.S. banks. In an article published in October, I discussed five reasons why I believe he is investing in the financials sector. A quick look at his positions reveals that Buffett is still bullish on the industry going into 2020 as well.
Bank of America Corp. (NYSE:BAC) is the guru’s second-largest holding and is the largest financial company owned by Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) as well. It proved to be a star performer in 2019.
Even on the back of a 43% gain last year and the declining interest rate environment, shares still seem to be an attractive investment for 2020.
Consistently beating analyst estimates for earnings per share was at the core of the bank’s stellar performance in 2019. It is expected to report fourth-quarter 2019 earnings on Jan. 15, and these numbers will likely set the tone for Bank of America’s performance this year.
Source: Company filings.
According to Priti Dhanuka, an analyst at Zacks covering the financials sector, Bank of America is likely to post another earnings surprise this Wednesday. Even though the Federal Reserve decided to cut rates three times in 2019, Dhanuka believes the slowly but steadily growing U.S. economy more than offsets the negative impact of declining policy rates by enabling the bank to win new customers and attract deposits while being able to grow its loan portfolio.
According to third-quarter filings, Bank of America had a Tier 1 common equity capital ratio of 9.7, whereas the minimum requirement is 4.5 according to the Basel III stipulations. The bank has been careful to maintain high Tier 1 capital because this helps in the approval of its buyback programs as well.
Data from the Federal Deposit Insurance Corp. revealed that Bank of America has the highest market share among deposit takers in the U.S. for the 12 months ended on June 30. Average deposits grew on a year-over-year basis in the third quarter of 2019 as well, despite the massive size of the bank.
Source: Third-quarter investor presentation.
Management said in the third-quarter earnings call that deposit growth at Bank of America has been consistently higher than the industry average for many years, which is something that will likely continue in the future.
Generally, interest rate cuts are seen as an obstacle for banks since net interest margins tend to compress in such an environment. However, as evident from the chart below, Bank of America’s net interest margins compressed by a negligible amount, resulting in higher earnings based on its loan portfolio growth.
Source: Third-quarter earnings presentation.
The third-quarter performance of Bank of America and other major banks helped ease the nerves of investors a bit. The largest banks grew their loan portfolios and deposits. According to the Financial Times, the demand for loans was also robust. In summary, the industry can survive if rates do not decline any further, which is the likely outcome in 2020 as confirmed by Fed Chair Jerome Powell in December.
Buybacks and dividends provide an income stream to investors
Bank of America likes to reward its shareholders with additional income, which is evident from its distributions in the recent past. According to data from Reuters, the bank has hiked its dividend in each of the last six years, which is proof of its commitment to provide an income to investors. At the market price of around $34.74 on Monday, shares yielded 2.07%.
The share repurchase program is attractive as well. In July, the bank authorized a new plan in which $31 billion is set to be distributed among investors through buybacks by July 2020. Even though this is not a liability, management will likely decide to go through with this plan as Bank of America remains adequately funded and highly profitable.
CEO Brian Moynihan had this to say about returning capital to shareholders in an interview with Barron’s:
“We buy back a lot of stock and invest in our people and our business. We don’t need the capital to grow. Unique to us and a few other banks, we can’t make acquisitions. So if we can’t buy anything, what should we do with the money? The right answer is give it back to shareholders because it’s their money.”
Bank of America will likely continue to reward investors for a very long time through buybacks and dividends, which sends a positive signal to income investors. The inability to find attractive growth opportunities leaves no other option but to distribute wealth to shareholders.
Valuation is at an attractive level. Wall Street analysts agree
It is a rare occurrence when many analysts agree on a large-cap company. In this case, however, the Street agrees, and many major investment banks have a “buy” rating or better for Bank of America shares.
Here are two of the noteworthy comments made by analysts who follow the bank.
Barclays’ Jason Goldberg wrote:
“The substantial improvements that BofA has made in its consumer bank, as well as the benefits of recent technology investments, are not fully appreciated by investors. We have a target price of $43.”
Wells Fargo’s Mike Mayo also has a positive outlook for the stock:
“Bank of America is delivering on the promise of national banking. With its investments in technology, it is creating a sustainable competitive advantage. In banking, Goliath is winning, and Bank of America is a leading Goliath. We have a target price of $42 for the next year and $50 for the next three years.”
The median consensus estimate for Bank of America shares is $37.31, which is 7.3% higher than the market price of around $34.77 as of Monday.
Source: Nasdaq
Shares are currently trading at a forward price-earnings multiple of 12.87. This is significantly lower than that of the S&P 500 Index, which is currently trading at a multiple of 24.57 according to Reuters data. Higher-than-expected earnings in the future will help shares converge with the median market multiple, and even a partial convergence will lead to healthy capital appreciation.
The quality of management can be seen in the results. Buffett approves the CEO
There’s no better way to determine the quality of a management team other than evaluating the financial performance of a company over a long period of time.
Investors need not go beyond the shareholder letter sent out by Warren Buffett (Trades, Portfolio) on Feb. 25, 2012, in which he said to trust the leadership of Moynihan following the financial crisis of 2008.
“At Bank of America, some huge mistakes were made by prior management. Brian Moynihan has made excellent progress in cleaning things up, though the completion of that process will take a number of years. Concurrently, he is nurturing a huge and attractive underlying business that will endure long after today’s problems are forgotten. Out warrants to buy 700 million Bank of America shares will likely be of great value before they expire.”
Such is the trust the “Oracle of Omaha” placed in the CEO almost eight years ago. As always, he was proven right in his decision to invest in the bank’s shares. As recently as last year, Buffett said Moynihan is one of the most underestimated bank executives currently and that his skills are not praised as much as they should be.
Buffet loves Bank of America; there’s no reason why investors should not
Last October, Berkshire Hathaway sought approval to increase its stake in Bank of America to more than 10%, which is the maximum allowed under the current regulations. In a filing signed by Buffett, the below explanation was given to the public:
“Berkshire may decide to purchase additional shares of common stock of Bank of America based on its evaluation of the investment opportunity presented by such purchases.”
There are many things to love about this bank, including the attractive dividend and buybacks, the fact that shares are trading at an attractive valuation point and the high-quality management behind the growth story. An economic recession is also unlikely for at least the next three years according to the World Bank and the International Monetary Fund. This provides reason to believe that the entire U.S. banking sector is in for a nice run for many years to come as a strong economy helps these institutions, and Bank of America will likely lead the charge, as it has done for the last five years.
Disclosure: I do not own any stocks mentioned in this article.
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This article first appeared on GuruFocus.