Tue, 6 Nov 2012
Bank of America's current management team has allowed the firm to have possibly the strongest capital position among major U.S. banks, says Oakmark's Bill Nygren.
Shannon Zimmerman: Bank of America is a company that had been in each of your funds, Oakmark and Oakmark Select. Was it ever in Global Select?
Bill Nygren: Yes, it was.
Zimmerman: So at Oakmark Select, it's been out for about a year. And now in the third quarter of this year, it has come back in, in a pretty big way. It's a top five position, I think, at Oakmark Select, about a 5% position. Talk a little bit about your thinking getting back into that company given the sort of regulatory overhang over the industry in general and Bank of America in particular. But then also given how valuation-conscious you are, the trajectory of the stock price has had pretty nice runup over the first part of the year and you entered in the third quarter even though Oakmark requires a pretty substantial discount to intrinsic value to make into a portfolio. What changed about your thinking that made you think that this company is deeply underpriced?
Nygren: I wish every time we sold a stock, it was because the valuation had gotten up to the level we thought it would get to. Unfortunately, we also sell when companies aren’t following the fundamental path that we were expecting.
When we sold Bank of America that was more the issue. It was not that the stock price had gotten too high, but it was the capital base that the company had was not standing up to the ever-increasing demands the government was making for capital.
We feared that there was more potential for shareholder dilution, which has been a very significant negative across the financial-services sector over the past four years. Over the ensuing year Bank of America did a good job of shedding assets--some through sales, some through maturities of securities that they owned--and they've actually gotten to a point now where their capital position is just about the strongest among the major U.S. banks.
We no longer had the fear that it was going to be years longer before Bank of America could return capital to shareholders. They've got a management team in place that is no longer the old acquisitive Bank of America management team where you could really question whether or not value was added for the shareholders. But this management team is very oriented toward return of capital, and the company has got a tangible book value of about $15 a share.
We believe that's a dollar-good number. We see no reason that the company shouldn’t be able to earn at least 10% on its book value. That would be $1.50 or higher in earnings, and the world that most of the bearers on the banking industry are worried about is a world where there is no loan growth. If there is no loan growth and there is no need for capital to continue building up in the business, that's a $1.50 that can be returned to shareholders. A typical bank today is paying out about 30% of its earnings as dividends. So that would be something like a $0.45 or $0.50 dividend on a stock that today is sub-$10.
We don’t see many companies today in the market yielding over 4%, and the company would be using the rest of that capital to repurchase shares. That will be about $1 per share for share repurchase, meaning that it could take out 10% of its shares annually. So even if there is no growth in the basic business, we think earnings per share at Bank of America could still grow at a double-digit rate.
Zimmerman: Over what period of time? Because if the core business isn’t expanding, isn’t that problematic over the long term?
Nygren: Well if the core business never expands and they take out 10% of their shares every year, which is the path that this management team is on, that never becomes a problem.
Zimmerman: How did you get comfortable with the current management team and their ability to allocate capital in a way that would be clear to you will be shareholder-friendly?
Nygren: Well, I think the easiest way is they went through a period where they were constrained by capital, and there wasn't much that they could do with that. So you know when they are capital-constrained they can't go out and make larger acquisitions. As they are exiting that period, it's seeing the stock ownership that they have, the incentives that are in place for them where they make more money if the stock price goes higher, and it's hearing them talk about how they think about capital allocation.
We have met with Brian Moynihan numerous times. He consistently talks about using share repurchase as a hurdle and how almost no acquisitions can be as value-additive as buying back Bank of America stock at less than two thirds of book value. You can’t go out and buy a healthy bank in an acquisition at two thirds of book value.
Zimmerman: Do you think that as Countrywide recedes in the rearview mirror that attitude might change over time?
Nygren: Well, I think maybe the fear of how bad an acquisition [of Countrywide was] might diminish. But I think the discipline of saying we can buy our own stock at two thirds of book value versus however much we’d have to pay for an acquisition, I think that discipline will remain and will guide the firm toward maximizing the value that it can add through its capital allocation.
Zimmerman: How do you have confidence in the value of a bank's book? What is the work that the team at Oakmark does to really scrub a bank's financials, which probably are the least transparent of all of the sectors, all of the industries?
Nygren: I'm not sure there that much less transparent than other sectors.
Zimmerman: Got to be careful of those "all's."
Nygren: Sometimes other sectors are just as hard to peel away the onion and figure out what's really in there as the banking industry is. I think investor concern about what's on a bank's balance sheet is probably at an all-time high. They got burned five years ago. Most of the assets on the banking industry's balance sheet relate to home loans. And banks got sloppy with how they decided to lend money, and there is no faster way for a bank to get in trouble than to lend money to people who won’t pay it back.
That changed abruptly at the end of 2007. So now we’re into five years of kind of good old-fashioned bank-lending standards. I think most anyone would say that loans that have been put on the books in the past five years are of substantially higher-quality than what were put on the five years ahead of that and are probably at least dollar-good today.
Then you look at the liabilities side of the balance sheet, and the banks are paying almost nothing for retail deposits. In today's world that advantage of cheap funding isn't getting them an awful lot because you can’t earn that much by investing those funds. But we think as interest rates normalize and get back up to levels that have been more historically average--and that might be three, four, five years away--we think the liabilities side of the balance sheet will prove to be a good asset for the banks because savings deposits are on the books dollar-for-dollar, but they don't have to pay as much on that as they would on a bond.