Bank of America Corporation (NYSE: BAC) or BAC is the second largest banking institution in the US after JP Morgan (NYSE: JPM) and is widely regarded as one of the Big 4 US banks, with Citigroup (NYSE: C) and Wells Fargo (NYSE: WFC) rounding up the Big 4.
The bank has operations across all common banking business lines and serves both individuals and institutions. This includes retail services, private banking, business banking, commercial banking, corporate and investment banking.
BAC also owns the Merrill Lynch franchise which is well known for its wealth management division.
The bank has more than $1.4 trillion in consumer deposits and 67 million consumer and small business clients. It serves more than 95% of the US Fortune 1000 and 77% of the global fortune 500 companies.
Why buy Bank of America?
1) Consistent share price outperformance
BAC has consistently outperformed the Bank Sector Index, indicating that this bank is above its peer group. In the last 5 years, it outperformed with a 25% increase in share price vs the Index’s 9% increase.
2) Valuation at all time low
BAC is trading at the lowest P/E ratio in the last 10 years. The current P/B ratio of 0.9x is also at the end of the last 10 year range of 0.8x to 1.5x. On the other hand, the dividend per share has risen substantially.
Looking at BAC’s income statement in the last 10 years, we can also see that the revenue and net income has increased.
3) Comparison to Peers
When comparing BAC’s valuation to its peer group, BAC has the second highest Return on Equity while trading at a low P/E ratio. It is worth noting that generally the sector is trading at relatively low P/E ratios as there are expectations that earnings would decline in 2023.
What are the risks of buying Bank of America (and other US Banks)?
Looking ahead, the economy is expected to slow down and this has broad consequences for the banking industry in general.
On 22 March 2023, the Federal Reserve increased interest rates by another 0.25% to 4.75%. A higher risk free rate means that the fair value of the various existing investment assets held by the banks such as treasury bonds has decreased. As the rate hike cycle is not deemed to be completed yet, the total asset losses could increase further.
The increased tightening also impacts other sectors such as the US commercial real estate sector and the US residential real estate sector.
Office utilisation has shrunk since the onset of the COVID-19 pandemic and the vacancy rate of office properties has increased. This has pressured rents and leasing activity for office landlords. Homeowners are also being pressured by job losses and higher mortgage burden from higher interest rates.
BAC, like any other commercial bank has significant exposure to this industry. Out of $1 trillion in outstanding loans, it has $70 billion in commercial real estate and over $250 billion in residential mortgage and home equity loans.
Why and How I did the trade?
Disclaimer: The author has carried out these trades in his personal capacity and is sharing his personal thought process, you should not carry out any of these trades merely from reading this article as your personal investment objective will differ from the author. Option trading can also be inherently riskier than other investment strategies.
Despite the risk, the valuation seems attractive. It is also worth noting that during this banking crisis, BAC was one of the beneficiaries as a flight to safety meant that more than $15 billion of deposits flowed into the bank.
With the bank’s diversified depositor base as well as portfolio of loans, it is also unlikely for a bank run to occur. Nevertheless, there are still risks which is why I have executed the trade by way of selling put options at a strike price of $22.
Although the book value of BAC is at $30.61, the tangible book value is $21.83 as BAC has goodwill on its balance sheet arising from past acquisitions. In addition, at a strike price of $22, the P/E ratio will be just under 7x, a level with adequate margin of safety.
Looking at the 3 snapshots above, based on the current market price, one can sell a put option with a strike of $22 for either a 28/56/84 days holding period until 21 Apr/19 May/16 Jun for a return of $0.40/$0.60/$0.80 respectively.
This trade allows me to collect a premium equivalent to the price of the option at the onset of the trade without owning shares. In turn, I agree to buy the underlying stock at the strike price if the contract is exercised. In this case, the strike price is $22.
Should BAC remain above $22, the return from the premium income received is approximately 1.8%/2.7%/3.6% over the holding period.
Should BAC fall below $22 during the option expiry, the purchase price after taking into account option premium will be below BAC’s tangible book value of $21.83 recorded at the end of FY22.
The reason for writing the put options across various timeframes are as follows:
- to secure premium income over a longer holding period should the strike remain above $22
- to be able to purchase the share at a net lower total cost should BAC goes below $22.
This is a much more prudent way then directly purchasing the stock or via call options as I will be able to purchase a good company at a low price or earn premium income of between 15% and 23% (annual compounded).
As I do not believe that the worst of the banking crisis is over and I am only comfortable to purchase at a price that is much lower than the current market price.
Due to the current market volatility, option prices are higher as more shareholders demand protection. Hence this would be a good opportunity to gain an exposure and benefit from the volatility without having an immediate direct exposure.
For investors who believe that the stock holds good value now or believe in a potential rebound, then the strategy would be to purchase the stock directly now or via call options.
Closing statements
It is also worth noting that one of BAC’s biggest shareholder is Warren Buffett himself with an 11.42% stake worth over $24 billion.
Although most of the stake was acquired in many years ago, the fact remains that he is still a shareholder. Buffett is known for disposing his stake when fundamentals of the company changes.
We have shared reasons to buy BAC, the risks at hand and also a strategy that the author has used in his personal capacity.
Together with the low valuation, this makes BAC a potentially viable long term holding. In the short term, due to the volatile and uncertain market, one may be better off taking a prudent approach with the trading strategy that has been shared.
You can learn more about options trading here.
