Recently I was thinking about fear and how it affects our investment decisions. In fact, fear is a natural reaction, a part of being human. It activates the fight-or-flight response that is vitally important when facing a physical danger. Thus a certain degree of fear is good because it allows us to survive. But at the same time, it is also the greatest obstacle that prevents us from moving forward. When you start pursuing your goals, you most likely will experience some feelings of fear. As a result your mind will come up with thousands of false evidences telling you why you can’t do it. There is a good acronym for FEAR that I like: False Evidence Appearing Real. These evidences might blurry the mind and make you believe that the goal is completely out of reach. Be prepared to unmask it.
Fear makes the wolf bigger than he is German proverb
When it comes to the financial industry, fear was all over the place during the past decades. The peak was certainly the global financial crisis and the failure of the investment bank Lehman Brothers in September 2008. The banking system was truly at the edge of collapse. In such market environment you normally don’t consider buying banks. However Warren Buffett did. He has not allowed fear taking over control and pumped $5 billion into Goldman Sachs during some of the darkest hours of the financial crisis. In the end it turned out to be a great investment for him.
More than one decade after the global crisis, there is a different environment today. The banking industry is in a much better condition. We see earnings growth, risk reduction and many other positive aspects. But still there is a noticeable fear that surrounds the banking sector. Sure, there are new scandals (money laundering as an example) that are feeding this fear. Nowadays, however, banks are less cyclical and in a better position to deliver good returns in the future. After checking my quality and valuation rating, I’ve decided to add my first bank to the SF portfolio.
On December 11, I have purchased 50 shares of Bank of America (BAC) for a total investment of €1,074.54 ($1,220.57).
Dividend: 2.36% | 5-yr. Dividend Growth Rate: 57.70% | Cons. Years of Dividend Growth: 5 | Payout Ratio: 25%
When looking at the dividend metrics, we see a well-rounded picture. The company has increased its dividend for five consecutive years and the latest dividend hike came in at 25%. What I really like is the combination of excellent dividend growth and a low payout ratio. Although such growth rates can’t be maintained long-term, there is plenty of room for Bank of America to continue with its shareholder friendly policy.
In this regard, earnings and revenue growth should be able to create a supportive environment. BAC has increased its earnings per share from $0.95 in 2012 to $1.83 in 2017. This is a CAGR of 14.01%. In the same period the revenue grew from $81.36 Bil. to $87.35 Bil. – a CAGR of 1.46%. This might appear as slow, but keep in mind that this bank has delivered revenue growth for 8 straight quarters.
Furthermore Bank of America has improved its operating performance. The 5-Yr. average net margin is sitting at 15.84%. What I like a lot is that expenses continue to decline while revenue grows. This results in a strongly increased profitability. BACs 5-Yr. average return on equity is 5.70% and shows a positive trend over the course of the past years.
Morningstar, an independent investment research company, measures a company’s sustainable competitive advantages. In this connection BAC achieves a narrow economic moat rating – which is the second best grade. Standard & Poor’s is a well-known international credit-rating agency. S&P rewards BAC with a good A- credit risk rating. Overall the company has achieved a four-star (good quality) grade in my quality rating.
The FastGraphs chart of Bank of America indicates that its stock price might be significantly undervalued. The current P/E ratio (black line) is 9.7, while the normal 5-Yr. based P/E ratio (blue line) is 15.3. By relating these figures we get the following Price/Fair Value ratio: 9.7/15.3 = 0,63. So this method assumes that the share price of BAC is 37% undervalued. Morningstar utilizes the discounted cash flow approach to find the fair value estimate. The investment research company predicts a fair value of $33. That would mean that BAC is currently 26% undervalued.
I like to consider different methods when it comes to valuation. The four-step valuation approach provides a good mix between historical and future value calculations. Running the numbers, I come to the result that BAC might be 34% undervalued based on four different methods.
I see following risks connected to an investment in Bank of America:
- Macroeconomic risk. As the rest of the financial sector, BAC is facing the risk of low interest rates that can result in a decrease in interest income.
- Regulatory risk. This remains a big threat for the whole sector. BAC could face fines or restriction that would have a negative impact on its profits and cash flows.
All in all, BAC appears to be a good quality business trading at a significant discount. This might also be the reason why Berkshire Hathaway has acquired additional $13 billion in bank shares recently. In fact, we observe a operating-friendly banking environment. Their earnings are growing, banks profit heavily from the tax reform and loan and deposit growth is great, too. And with banks having underperformed the broader market in 2018, the valuation has arrived at a very attractive level. That being said, I like this sector and will continue to watch it closely.