Financial services stocks are dealing with the hurdles of three interest rate cuts this year. Although this is often a recipe for problems for the sector, with just a few weeks left in the year, bank stocks are actually looking pretty good … perhaps very good.
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The widely followed KBW Bank Index is up 28.54% year-to-date thanks in part to a stellar 15.42% jump since the start of the fourth quarter. Bank of America (NYSE:BAC) isn’t just participating in the bank equity rally, it’s one of the party’s leaders. Shares of Bank of America are outpacing the aforementioned KBW Bank Index by nearly 600 basis points this year and that out-performance could carry over into 2020.
Yes, it’s possible that multiple interest rate cuts could be in the offing in 2020, particularly with it being an election year and if economic data weakens. However, Bank of America and several other large money center banks have been proactive in managing investors’ expectations when it comes to net interest income, the corner of banks’ balance sheets most affected by declining interest rates.
For example, Bank of America reported third-quarter net interest income of $12.1 billion, only slightly below the Wall Street estimate of $12.2 billion. Net interest margins and related expectations are important to Bank of America stock and shares of rivals. Even the Federal Reserve admits as much.
“Banks’ interest income for a given level of interest-bearing assets should generally rise as the FOMC raises its policy rate, and as longer-term rates rise, because banks can pass on rate increases to borrowers through floating-rate loans and new fixed-rate loan originations,” said the Fed in a research report out earlier this year. “Similarly, banks’ interest expenses should rise, or at least not fall, as banks may pass through higher interest rates to savers.”
A Value Feel
Although Bank of America has generated impressive returns this year, acting the part of a high-flying growth stock, the shares are remarkably cheap at 11.14x 2020 earnings. That underscores the point this is a value stock, a potentially beneficial trait at a time when there is plenty of talk about a growth-to-value rotation.
The stock’s status as a value play is appealing, but that allure isn’t risk-free because the value factor has flaws, some of which have been vexing academics and market observers for years.
“The reasons for this putative failure of value investing elude investors and academics, making it a challenge to assess the likelihood of the return of value investing to its days of glory,” according to a study on value stocks conducted by the NYU Stern School of Business.
Adding to the allure of Bank of America is that it offers investors some insulation from lower interest rates due to the diversity of its business model, which includes the Bank of America Merrill Lynch brokerage business.
“The bank also has one of the largest online retail brokerages in Merrill Edge and one of the largest advisor forces through Merrill Lynch Wealth Management,” according to Morningstar. “The bank is a top five global investment bank, one of the largest U.S. issuers of credit and debit cards, one of the top four U.S.-based merchant acquirers, and a top five fee earner from FICC products globally.”
The Bottom Line on Bank of America
Although Bank of America’s operating efficiency has been poor relative to its peers, it is improving thanks to branch consolidation and other cost-saving moves. In order for efficiency to morph into a legitimate catalyst for Bank of America stock, it doesn’t need to be better than say JPMorgan (NYSE:JPM) or Wells Fargo (NYSE:WFC), it just needs to be in the ballpark of those rivals.
Cost synergies, increased emphasis on more credit worthy customers and the moat associated with the company’s brokerage and investment banking operations are catalysts to drive cash flow, helping Bank of America direct more cash to buybacks and dividends, the latter of which can easily grow because the stock yields just 2.18%.
As of this writing, Todd Shriber did not hold a position in any of the aforementioned securities.
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