Warren Buffett, one of the greatest investors in the world, has always been known for his positive attitude towards financial stocks. All the more surprising, it seems he cut his stakes at JPMorgan (JPM) and Wells Fargo (WFC). Buffett’s Berkshire Hathaway (BRK.A)(BRK.B) also exited Goldman Sachs (GS). But still, one of the company’s largest portfolio positions is Bank of America (BAC). The latter is set to report its earnings on Wednesday, October 14. Here I will talk about this stock’s risks, merits, and analysts’ earnings expectations.
I prepared an outline of Berkshire Hathaway’s portfolio as of June 30. Financial stocks still seem to be significant for Berkshire’s portfolio and Bank of America plays an important role too.
One of the stock holdings Berkshire cut was JPMorgan. Earlier on I wrote about this strange fact. In my view, in spite of the bank’s superb investment characteristics, it looked quite expensive compared to Bank of America’s stock.
At the same time, it seems, financial stocks as well as other “cyclicals” are true bargains. High-tech stocks, in contrast, look quite overheated right now.
Financial stocks have had a tough time this year, indeed. As we all know, due to the coronavirus pandemic, the interest rates are now stuck at zero. What’s more, the minutes recently published by the Fed suggest they will stay so until the end of 2023 at the latest. This is, obviously, a problem for banks, since a lion’s share of their profits is actually due to the net interest income.
Moreover, some of the Fed’s members, most notably Eric Rosengren, expect a wave of defaults and bankruptcies. The main reason here is the fact that interest rates have been staying low for a while. So, many smaller businesses and individuals have been borrowing a lot. They are even more encouraged to do so nowadays. However, many of them cannot pay their debts back because of pandemic-related economic hardships. It looks like banks will lose plenty of money because of that. This seems to be a major risk to the financial sector.
However, are not all these problems already factored in the current valuations? As can be seen from the graph below, the financials have underperformed the S&P 500 index this year. As of the time of writing, the S&P 500 rose by 19.14%, whereas the S&P 500 Financials fell by 5.77% this year.
S&P 500 vs. S&P 500 Financials
Source: S&P Global
True, S&P 500 might not be an excellent indicator at all since a large part of its capitalization is due to the high-tech sector. In fact, high-tech stocks have even gained from the coronavirus lockdown. But still, this indicator makes financials look quite undervalued right now.
Bank of America stock – a worthy investment?
Surely, BofA is the second-largest US bank by the value of assets held. As can be seen from the chart below, it is not much smaller than JPMorgan. It looks like Bank of America is almost “too big to fail.”
Largest Banks in the US by assets held
However, a lion’s share of BofA’s earnings is due to consumer banking or retail banking. This refers to providing financial services to private individuals. Such services include accepting deposits and lending money as personal loans or mortgages. In my view, it is even riskier than financing businesses. Private individuals are more likely to become insolvent on their debts. In plain terms, it is enough for a private individual to just lose a job and fail to find a new one soon enough. It looks particularly true of people working for companies like airlines or hotel chains, which are really struggling now.
What’s more, many prudent people are unwilling to borrow nowadays when there’s so much uncertainty about the future. So, the demand for consumer loans has probably stayed quite limited over the past several months too.
What I also dislike about consumer banking is people’s unwillingness to deposit money when interest rates are so low. Instead, they prefer to invest in the stock market, which is near its all-time highs nowadays. It is, in my opinion, quite a bubble set to burst. If it bursts, the banking industry will be affected too.
Source: Author, BofA’s quarterly earnings, page 1
Here’s what to expect this earnings season
Although a number of analysts actually raised their earnings expectations the past 30 days, Bank of America is still expected to report poorer results than it did last year. Zacks predicts BofA will report quarterly earnings of $0.48 per share. This means a year-over-year change of -14.3%. As concerns the bank’s revenues, it is estimated BofA will post $20.64 billion, which is a fall of 9.5% from the year-ago quarter.
In my view, BofA would have probably been better off focusing more on rich clients and wealth management. Richer clients usually tend to be less of a risk. What’s more, banks’ trading revenues normally soar when there’s a volatility spike.
Buying a stock just ahead of the earnings report is always a risk. It seems even more so in the case of cyclical businesses like banks. There is a probability the bank will report better-than-expected results. But I would not be surprised if they turn out to be worse.
All that does not mean I do not recommend buying Bank of America stock. It is the second-largest bank in the US and rated A2 (high investment grade) by Moody’s. What is more, it is trading at lower multiples than its rival JPMorgan Chase. Finally, I like to be contrarian and always support investors buying large companies that are selling for peanuts. But I’d buy Bank of America just like any other bank after a pullback, not before a potential stock price plunge.
Bank of America is the second-largest bank in the US and the second-largest holding of Warren Buffett. It has a good reputation. But its stock, just like other financials, has underperformed this year. It is highly likely the bank will report lower earnings than it did last year. There is a risk they will be even lower than expected too. But Bank of America just like many other giants in the financial sector will be a very smart buy after another stock market crash, I think.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.