By: Dividend Sensei
It’s understandable that after the financial crisis of 2008-2009, which nearly destroyed the global banking sector, many investors prefer to shy away from banks entirely. However that might be a mistake. Because one bank in particular has managed one of the most impressive turnarounds in corporate American history. In the process it’s turned itself into a profit minting machine that is poised to potentially deliver strong dividend growth and market beating returns for years to come.
Bank Of America: Growth Engine Firing On All Cylinders
Bank of America has totally turned around its banking culture since CEO Brian Moynihan took over after the financial crisis. The bank closed 25% of its branches, cut billions in annual costs, and now makes most of its consumer loans to those with FICO scores that average 750. For context the average US FICO score just hit an all time high of 700. This shows that Bank of America is making very safe loans, yet is still able to generate sensational profit growth.
In Q1 2018 it saw saw revenue rise 3%, cut costs 5%, and thanks to tax cuts, EPS soared 43%. More importantly the banks profitability is also hitting new all time highs.
- Return on assets: 1.17% (Industry average 0.87%)
- Return on equity: 15.2% (industry average 8.4%)
- Efficiency ratio (non interest expenses/revenue): 59% (down 2.5%)
The 3 most important profitability metrics in banking are return on assets, return on equity, and the efficiency ratio. The rule of thumb is that a bank is considered well run if it’s ROA is 1% or higher, ROE is 10% or higher, and efficiency ratio is under 60%.
Bank of America’s profitability is head and shoulders above its peers, and is only getting better over time. BAC has managed to cut costs in 13 of the last 14 quarters, thanks largely to transitioning customers to digital banking. That allows them to retain and grow their customer base (and assets) while closing physical locations with high fixed overhead costs. In the Q2 2018 24% of the banks total banking activity was done online, up from 16% three years ago. This trend of ever leaner operations is expected to continue with analysts expecting BAC’s efficiency ratio to fall to 51% by 2022. That would make Bank of America not just one of the most efficient and profitable banks in America, but the entire world.
That profitability is why Bank of America just announced a $21 billion in new buyback authorization for the next year (enough to buyback 7% of its shares). It also hiked its dividend an impressive 25%. Those capital returns are not just a testament to the bank’s sensational turnaround, but it’s fortress like balance sheet. That’s because the Federal Reserve (which regulates US banks) had to authorize the capital return plan, and only after Bank of America could prove it will likely sail through future recessions with ease. It just did that so impressively that I’m confident that it can not just survive future downturns, but even remain profitable during a recession and maintain its dividend.
Fortress Like Balance Sheet Means Dividend And Company Should Easily Survive Future Recessions
The biggest thing many investors fear is that another financial crisis will strike and once more blow up the US banking sector. And indeed a dividend stock whose dividend can’t be depended on isn’t worth owning. However Bank of America’s balance sheet has been built into a fortress that should easily survive the next recession, all while allowing it to maintain its dividend throughout the downturn. How do we know?
Because each year the Federal Reserve, conducts an annual stress test. This simulates a severe global recession, to test whether or not a bank’s capital base can withstand major loan and investment losses, without requiring a a bailout. If a bank fails the test it isn’t allowed to increase its capital returns to investors (buybacks or dividends)
This year’s stress test was the most severe of all, simulating a much worse economic catastrophe than what occurred during the Great Recession. In fact it was the toughest stress test ever conducted.
- Recession duration: 3 years (Great Recession was 18 months)
- Peak unemployment: 10% (unchanged from 2017 or Great Recession)
- Max fall in stock prices: 65% (up from 50% in 2017 and 54% in Great Recession)
- Peak decline in home prices: 30% (down from 35% in 2017 and 33% in Great recession)
- Peak decline in commercial real estate: 40%
- Peak GDP decline: 8.9% (up from 6.5% in 2017 and 5.1% in Great Recession)
A recession that has caused US GDP to fall by 8.9% hasn’t been seen since 1945, and that was caused by the end of World War 2, when massive DOD spending cuts caused a brief, but severe contraction.
Since 1945 the average US recession has seen US GDP fall by 2.1%, or 76% less than what the Fed just modeled. What’s more recession don’t usually last three years. The last time one did was the economic crash that kicked off the Great Depression. How did Bank of America hold up under this worst case scenario?
It passed with flying colors. The regulatory minimum that all banks need to hit is a supplementary leverage ratio (value of total assets over total leveraged assets, both on and off balance sheet) of 4%. This is the new international gold standard for safe banks that don’t need a bailout. BAC’s fells no lower than 4.6%, even in the face of a total global economic apocalypse.
That tells us that it’s fortress like balance sheet could not just survive the next recession, but that it’s dividend would likely be maintained as well. This is why I feel comfortable now recommending Bank of America as a long-term income investment.