The stock market has been strongly impacted by the coronavirus, which triggered a selling wave in all equities. Large banking corporations, like Bank of America (BAC) or Wells Fargo (WFC), have seen their equity values decline by 50%, whereas the stock market in general stopped the decline at 30%. A number of equities have started a V-shape recovery, whereas the major banks are still recovering from their recent 52-week low levels.
Bank of America’s business model is negatively impacted by the lower interest rates and the increase of the credit provisions, as a consequence of the COVID-19 virus. This has pushed the current valuation of the bank to an all-time low level, which is not in line with the long-term intrinsic value.
We expect the stock price of BAC to retrieve to its previous high levels of $33 and will present an investment idea which investors and traders can use to benefit from this potential pullback.
Price Performance during the COVID-19 correction
Bank of America stock price corrected by 50% during March 2020 as the coronavirus caused a selling spree in the stock market. The stock price went as low as $17.95, a level we had not seen in the last 3 years (since November 2016).
After this new multi-year low-level was reached on March 23, 2020, investors gained their trust again in the stock market and equity prices started to rebound. BAC followed the rise in the broader stock market but lagged behind.
At the moment of writing this article, the S&P 500 (SPY) is still 10% away from its previous 52-week high level, whereas BAC is still 33% below its top level. The same can be said for the financial sector (XLF), but even here BAC is underperforming.
When we look at its performance during the second half of the previous month, we can see Bank of America is starting to catch up with the stock market in general.
The stock price rose strongly on May 26 and 27 with above-average volume. While there still is a long way to go, it seems investors and large funds are purchasing bank stocks again in their portfolio.
Another way to visualize the sentiment on BAC can be seen from the implied volatility levels over the past weeks.
(Source: Chart created by author with TWS from Interactive Brokers)
The white line in the chart represents the implied volatility for BAC, which is the volatility the stock is expected to face in the coming period. High IV levels are seen when investors are fearful. The implied volatility has full retraced back to its low levels pre-coronavirus.
Effect of COVID-19 on the fundamental value of BAC
Briefly summarized, the fundamental value of BAC is negatively impacted by the following two items:
- Increase in Credit Provisions – The bank increased the provision for credit losses from $1 billion to $4.8 billion in Q1 2020 (compared with Q1 2019). This $4.8 billion provision consists of 2 parts:
- Net charge-offs of $1.1 billion (which is in line with the Q1 2019 figure)
- Reserve builds for $3.6 billion (no value was provisioned here back in Q1 2019.
Consequentially, the Net Income of BAC declined with 45% year over year, as the reserve builds consumed a major part of the total revenues, which were only 1% below the previous-year results.
(Source: Q1 2020 report from BAC Investor Relations website)
This decline in EPS had a strong impact on the profitability ratios for the quarter. Return on average assets and the return on equity were cut in half:
- Decline in Interest Rates – In reaction to the coronavirus, the Federal Reserve has lowered the target interest rate, which will have a negative impact on the interest income of BAC.
Taking these two negative impacts into consideration, we believe the impact on the bank’s fundamental value and earnings power will be limited in the future. The $3.6 reserve build-up during Q1 2020 is a one-time thing for which BAC is sufficiently capitalized to bear the impact. While the size of the reserve is considerable, we expect the impact to fade away in the years to come.
As for the impact of the lower interest rates, we need to consider only half of BAC’s income is originating from the interest income segment. Over the period from 2018-2019, the rate dropped as well by 75 basis points, which had only a limited impact on the net interest yield of BAC, which declined by 17 basis points.
The strong decline in stock price has an outspoken effect on the bank’s valuation multiples.
The P/E ratio, P/S ratio, and P/B ratio are all at the lowest level they have been in the last 6 quarters. We expect Bank of America to retrace to its previous valuation ratios as the earnings will pick up again.
Investment proposal with an improved risk-reward ratio
In order to benefit from a potential rise in BAC stock price, we would recommend purchasing call options on Bank of America. These call options require a low investment amount compared with common stocks and offer a similar profit profile.
More specifically, we would recommend purchasing the January 15, 2021 calls with a strike price of $25 for a premium of $264. This investment has the following characteristics:
- The purchaser of the call option will have a right to purchase 100 stocks of BAC at $25 at any time before January 15, 2021.
- The maximum loss is limited to the premium one has to pay to purchase the call options of $264. In extremis, if BAC would decline to $10, you would only lose $264.
The profit profile of these call options can be compared with the profit profile of a common stock purchase in BAC:
(Source: Created by the author using data from Yahoo Finance)
As you can see from the red line, the total loss of the call option investment is limited when we compare it with the total (potential) loss of common shares.
The price of the call options in any stock or commodity is mainly driven by the volatility of the underlying asset. Investors assume a certain volatility level will be applicable for the period to come – the implied volatility level – which will have a direct impact on the price of the call option. The higher the implied volatility, the higher the premium of the call options. As demonstrated by the graph in the first section of this article, we can see the implied volatility for BAC has decreased significantly in the previous weeks.
Risks of the trade
As always, we do want to ensure investors are fully aware of the risks which come with an investment in equities and derivatives.
Bank of America has recently gone through a volatile period, which has strongly lowered its market value. Once the volatility would return to the stock markets, for example, if a second COVID-19 wave would occur, we can expect BAC to decline lower.
We have looked at the impact of the credit provisions and the lower interest rates on the future earnings power of BAC. If the economy would go into a recession, we can expect these two factors to have a more severe impact on the earnings of BAC.
Another risk we would like to emphasize is the time period in which we anticipate the stock rise of BAC will occur. In order for the call option investment to be profitable, the stock price of BAC has to rise to the $27 level before mid-January 2021. Otherwise, the call options will expire worthlessly.
Disclosure: I am/we are long BAC. 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.