Bank Of America: A Dividend Growth Stock That Benefits From Rising Interest Rates

Few investors will ever forget the terror of the financial crisis of 2008-2009, when the global financial system was on the verge of complete collapse and many people were convinced we were headed for another depression.

Shareholders of U.S. megabanks such as Bank of America (BAC) were especially brutalized when one of America’s largest banks came within a stone’s throw of complete insolvency and saw its shares fall over 90% from their all-time high.

Understandably, large banks have been incredibly out of favor since then, despite what has been one of the most impressive turnarounds in corporate America. In fact, Bank of America’s efforts allowed it to raise its dividend by 50% earlier this year, and more payout growth could be ahead. Warren Buffett owns a number of banks in his dividend portfolio as well.

Let’s take a look at just how far Bank of America has come since the dark days of the Great Recession and if its shares might represent a solid, if still high-risk, long-term opportunity for dividend growth investors.

Business Description

Founded in 1874 and headquartered in Charlotte, North Carolina, Bank of America, with almost $2.2 trillion in total assets, is the world’s 9th largest bank and the 2nd largest U.S. megabank.

It primarily operates in four main business segments but with two-thirds of net income coming from its core consumer and corporate banking divisions:

• Consumer Banking: providing retail banking services such as checking, savings, and money market accounts, as well as credit and debit cards through its 4,700 banking centers and 16,000 ATMs.
• Global Wealth & Investment Management: wealth management, brokerage, and retirement services.
• Global Banking: commercial, and real estate loans, revolving credit facilities, merger & acquisition consulting, debt, and equity underwriting
• Global Markets: market maker on numerous global exchanges, risk management, securities clearing, settlement, and custodial services, treasury bonds (helps US government sell freshly issued debt), and mortgage-based securities

Source: Bank of America Earnings Presentation

Business Analysis

When current CEO Brian Moynihan took over in 2010, Bank of America was a catastrophe. Under previous CEO Ken Lewis, the bank acquired both Countrywide Financial (the home mortgage originator) and Merrill Lynch; two decisions that Morningstar’s senior banking analyst Jim Senegal dubbed “some of the worst capital allocations decisions of all time”.

Mr. Senegal isn’t being hyperbolic, as Countrywide and Merrill Lynch ended up exposing Bank of America to over $200 billion in legal fines, compliance fees, and enough exposure to toxic debt that it nearly bankrupted the company.

Fortunately, Brian Moynihan is a completely different banker than Ken Lewis (who was a huge fan of risky speculation in highly leveraged mortgage-backed security derivatives and credit default swaps), who has spent his tenure laser focused on creating a far more conservative banking culture.

This can be seen through three major initiatives:

First, Moynihan sold off much of the bank’s underperforming business segments to focus on the bank’s core businesses, which allowed for massive cost cuts. However, unlike many banking rivals, Bank of America has spent the last six years trying to build a permanently leaner corporate culture, as seen with management’s ongoing $3.3 billion in annual cost savings the bank is targeting by the end of 2018.

Even more importantly, after the trauma the entire banking industry experienced in 2008, Bank of America has focused on creating a fortress-like balance sheet, one strong enough to withstand an economic shock even worse than the Great Recession.

As you can see, Bank of America’s Basel III common equity Tier 1 capital ratio (the most conservative form of comparing a company’s working capital to its risk-weighted assets) has been steadily climbing over the years. In fact, since 2010, under Moynihan’s leadership, the ratio has risen 55.2% from 7.6% (very weak balance sheet) to 11.8%.

(Click on image to enlarge)

Source: Bank of America Earnings Presentation

Current Federal regulations dictate a minimum of 8% to ensure a bank can remain solvent (and avoid needing a federal bailout) even during an economic shock. In order for a bank to be allowed to return capital to shareholders via buybacks and dividends, a bank needs to prove that doing so won’t result in its reserve capital being too weak to survive a worst-case economic scenario.