Bank of America's (NYSE:BAC) year-to-date slump shouldn't be a surprise as it is a cyclical asset that exhibits excess sensitivity to the broader market. I wanted to cover the stock as I believeWarren Buffett's favoritebankis in a binary situation. I say this because the bank portrays solid performance attributes in some areas but tremendously weak features in others.
I did everything I could to formulate an independent, objective, and accurate conclusion for our readers. Here's what I encountered.
Operational Review & Risk Analysis
Firstly, let's run through the bank's Basel III framework, as it's the cornerstone of most banks' financial health. If this part of the article is trivial to you, I suggest skipping to the next, as some of the "down the line" content isn't something you'd see in a typical investment article.
Although not compulsory, the Basel III framework is a globally accepted stress test published by banks. The framework measures a bank's invested allocated risk and is a helpful indicator of efficiency.
According to Bank of America's 2022 Basel III stress test results, the bank exceeds risk/return expectations. Bank of America's tier 1 capital ratio exceeds the regulatory requirement (10.5%), meaning its core business activities are well covered.
Relative to its stress test results, Bank of America's operations carries solid risk/return prospects. However, a holistic analysis is required to juxtapose the argument.
Bank of America
Bank of America's second-quarter earnings miss was a bit of a surprise to me. The bank generates approximately50%of its revenue from interest-bearing activities, meaning it's likely to benefit from rising interest rates in most instances.
The bank's interest-based income rose by22% year-over-year, driven by higher rates. However, its non-interest income receded by 9% during the same period due to lower banking fees, 2022's bear market, and a range of mark-to-market positions that didn't settle favorably.
Most banks contain three segments: lending, trading, and services. Much of Bank of America's revenue mix relies on credit. Therefore, it runs a high-risk business model. I believe the debt market is heading for a wobble in the current economic climate, and Bank of America could be dragged down with it.
As for non-interest activities, it's possible that this segment could recover as the worst of 2022's bear market is likely over, and calming financial markets could pivot the bank's trading activities as well as its fee-based business.
Factor Analysis & Valuation
It's always beneficial to understand how market participants categorize a stock. Therefore, I ran a cross-sectional regression on Bank of America stock to segment the asset. The regression compared the stock's historical returns relative to various "market climates".
What are market climates? It's a measure of what the investment appetite is during different stages of the economy. For example, is the market searching for value, growth, high dividend stocks, etc.?
My regression discovered the following. Note that I added the variable denotation at the end of each statement. The denotation is the influencing variable, and its result is its influence on the stock's historical closing price.
- Bank of America outperforms the broader market whenever we're in a bull market - Mkt-Rf.
- The stock underperforms whenever investors seek small-cap stocks. Investors usually seek small-cap stocks whenever the economy's running hot - SMB.
- Bank of America outperforms whenever the market seeks value stocks - HML.
- This is a momentum-conducive stock. As such, it's likely to outperform its peers whenever the broader U.S. stock market follows a momentum trend - MOM.
- The regression also shows that Bank of America is a short-term mean-revering asset - FF-STREV.
- The security outperforms whenever low-beta stocks outperform, which could be a large value-add in a bear market.
Portfolio Visualizer
Based on the stock market's year-to-date performance (diagram below), it prefers high-dividend, value, and low-volatility stocks. Gleaned from our factor regression, Bank of America aligns with low volatility and value; however, the stock doesn't align with quality, which would've been beneficial in today's risk-off market environment.
KoyFin
The factor analysis indicates that Bank of America will likely underperform the market for some time. Economic contractions (such as the one we're in) demand that stocks load on quality, low-volatility, and high dividend factors. And Bank of America stock simply doesn't load on these factors.
Valuation
I implemented an array of valuation techniques to frame a scenario analysis. TheGordan Growth Model(GGM)measures a stock's intrinsic value by discounting a company's dividend prospects. The model does this because its fundamental belief is that companies will compensate their investors within the realms of their earnings growth.
I modeled two GGMs, with the first utilizing Bank of America's 3-year dividend CAGR while the second model is based on the bank's current dividend growth per share. This provides us with best and worst-case scenarios.
Based on the GGMs, a high earnings growth scenario classifies the stock as severely undervalued. However, a slowing earnings growth scenario analysis suggests the stock's slightly overvalued.
Pearl Gray Equity and Research; Seeking Alpha
You can derive a stock's future intrinsic value by multiplying its expected earnings-per-share by its price-to-earnings. I pulled the necessary earnings estimates fromSeeking Alpha's databaseand discovered price targets for December 2022 and December 2023. The results convey that the stock is infinitesimally undervalued.
Pearl Gray Equity and Research; Seeking Alpha
The final valuation metric that I engineered is the stock'sjustified price-to-book ratio. Bank stocks load heavily on their tangible book value, and a price-to-book value above1xis usually considered overvalued.
Furthermore, a justified valuation (see the table above) tells us what a stock-specific valuation threshold is. According to the justified price-to-book formula, Bank of America's current price-to-book valuation threshold is at 0.55x and not 1x.
Bank of America's market price-to-book ratio of1.05xsuggests the stock's overvalued relative to a conventional valuation threshold as well as a justified threshold.
Pearl Gray Equity and Research; Seeking Alpha
Most metrics indicate that Bank of America's fundamentally overvalued. Thus, the stock's risk Vs. return prospects are questionable.
Economic Variables
I want to consolidate my bearish outlook on Bank of America by reviewing a few macroeconomic variables. Bank stocks are susceptible to the broader economy. Therefore, a bank stock's performance is interlinked with systemic risk.
Arecent articleof ours explains the current macroeconomic climate rather well. So, I decided to embed a screenshot below.
Pearl Gray Equity & Research; The Factor Investing Hub
The dataset below backs up my statement. Global economic matters are getting worse by the day, with a European energy crisis, global monetary despair, and rising civil unrest being central to today's systemic implications.
The stock market could capitulate if these issues persist, and Bank of America could be caught in the middle of it all as its cyclical attributes would exacerbate matters.
Concluding Thoughts
A factor analysis indicates that Bank of America stock doesn't load on risk-off influencing variables. Furthermore, various valuation models suggest that the stock holds little intrinsic value, which could be exposed if the current economic climate persists. The bank's operating results could pivot as interest rate hikes settle, and the broader financial markets find calm.
We assign a sell rating to Bank of America as we believe a sum of the parts conveys that the stock's risk versus return prospects are poorly aligned.
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