In our opinion, Bank of America (BAC) is the best-run U.S. national bank, and it’s the only U.S. bank stock that we currently recommend, explains Scott Chan, contributing editor to The Complete Investor.
The company reported a very solid third quarter. Net interest income — the interest difference it earns between its assets and liabilities — was up 9.5% year over year to $11.1 billion. To be fair, as is the case with many companies, the pandemic made 2020’s third quarter an abnormally weak benchmark.
Still, when compared sequentially to the second quarter of this year, third-quarter net income was up 8.4% ($861 million). Non-interest income — from various service fees — was up 3.9% sequentially. Non-interest expense fell 4%. Obviously, higher revenue and lower expenses are a great combination.
The increase in net interest income was driven primarily by higher interest received from debt security investments ($462 million) and U.S. commercial loans ($266 million), reflecting both more capital being deployed and higher yields.
Keep in mind that banks borrow at short-term rates and lend at long-term rates, pocketing the difference. Thus, Bank of America has benefited from the widening yield spread this year. This is an important development.
We have long expected that commodity scarcities eventually would lead to future high inflation. But now the market itself is also anticipating higher inflation, which, all things equal will lead to a rise in long-term interest rates. That bodes well for Bank of America’s earning power, as long as inflation doesn’t run so high as to cause a recessionary hiccup.
On the cost side, the efficiency ratio — calculated by dividing expenses by revenue — is likewise headed in the right direction. The metric improved to 63.4%, compared to 70.1% in the second quarter. The company’s goal is to lower it back down to pre-pandemic levels, below 60%. Successful cost control adds operating leverage, as earnings increase faster than revenue.
Important for income investors, along with growing earnings, the dividend has risen at a fast pace. Bank of America has just increased its quarterly dividend to $0.21, or $0.84 on an annualized basis. Five years ago, the payout was only $0.075 per share per quarter.
This marks a five-year annualized dividend growth rate of 22%. The payout ratio is below 45%, so the growing dividend is well covered by earnings.
Despite growth in the bank’s earnings and dividend, the shares still trade at a modest 14 times projected forward 12-month earnings. As a comparison, the S&P 500’s forward P/E ratio is north of 20.
The 2008 financial crisis no doubt still leaves a sour taste in many investors’ mouths, and persistently low interest rates, which as noted above limit net interest income, likely also have contributed to lackluster valuations for banks.
While Bank of America did reach the brink of collapse during those dark days — partly driven by absorbing Merrill Lynch at the height of the crisis — today it is on much surer footing, and it held up well during the pandemic. If the company continues to execute with growing earnings, margins, and dividend, there’s a good chance the valuation gap will narrow, providing an extra return boost.
