[October.2024] Buffett cut position: Can Bank of America handle the pressure?

Warren Buffett has long favored Bank of America, once Berkshire Hathaway's second-largest holding. However, markets changed. Since early 2024, Buffett has significantly reduced his stock holdings, including billions in Bank of America shares, lowering its rank in Berkshire's portfolio.

His moves, often seen as market indicators, caused a brief dip in the bank's stock price. But the long-term outlook depends on its earnings performance.

On October 15, Bank of America will release its latest earnings report. Each earnings release may signal a potential investment opportunity, but before diving in, investors need to understand how to interpret their financial statements.

We may focus on three key areas to analyse Bank of America's earnings: earnings stability, risk indicators, and shareholder buybacks.

1. Earnings stability

Bank of America's revenue has two key segments: net interest income (interest from loans minus interest paid on deposits) and non-interest income (fees, asset management, trading revenue, etc.).

Like most banks, its performance is generally stable, with minor fluctuations tied to economic cycles.

Over the past decade, revenue has grown modestly from $88.94 billion in 2013 to $98.58 billion in 2023, a 10% increase. While not spectacular, this reflects steady progress.

Net income, however, has shown stronger growth, rising from $10.08 billion to $24.87 billion, a 1.5-fold increase.

This period can be divided into two phases. From 2013 to 2018, higher profit margins from net interest income drove significant profit growth, even though non-interest income remained stable. By 2018, net income had surged to $26.7 billion.

From 2019 to 2023, Bank of America's net income fluctuated due to factors like taxes and loan loss provisions but generally remained stable, hovering around $25 billion most of the time.

The bank's revenue and profit stability in recent years largely stems from the balance between its net interest income and non-interest income.

During periods of Federal Reserve rate cuts, net interest income may decline, but increased market activity often boosts trading fees and asset management revenue. Conversely, during rate hikes, net interest income benefits, while non-interest income might take a hit due to market volatility.

In recent quarters, as the rate hike cycle ended and expectations of rate cuts grew, Bank of America's net interest income has been pressured by rising deposit costs, showing year-over-year declines for three consecutive quarters. Meanwhile, non-interest income has remained stable or slightly increased, reaching near three-year highs.

Looking ahead, with the Fed expected to cut rates starting in September, net interest income may face further pressure. Despite short-term uncertainties, the key focus may be on the bank's long-term performance. If Bank of America can maintain its historically stable earnings, investors may not need to worry. However, consecutive years of declining performance could raise doubts about its investment certainty.

2. Changes in risk indicators

Banking fundamentally involves earning a spread—attracting deposits at low interest rates and lending them out at higher rates. This results in banks having relatively little equity compared to their total assets, leading to high leverage. For instance, Bank of America's latest debt-to-asset ratio is a staggering 90.8%. While such high leverage is unthinkable in most industries, it's common in banking.

This high leverage brings potential risks, as banks are crucial pillars of the financial system. Widespread bank failures can destabilize the entire financial market. Hence, regulators impose stringent requirements on certain financial metrics for banks.

One key metric is the Common Equity Tier 1 (CET1) Capital Ratio, which measures a bank's core capital (common equity and retained earnings) against its risk-weighted assets. This ratio, set by the Basel Committee on Banking Supervision, has a minimum requirement of about 4.5%. Additionally, banks may face country-specific capital buffer requirements, generally not exceeding 11%.

As of Q2 2024, Bank of America's CET1 ratio stands at approximately 11.9%, significantly above the Basel requirements and exceeding many other regulatory standards.

The second metric is the NPL ratio, which measures the percentage of loans that are past due by 90 days or more. This metric indicates the quality of the bank's loan assets. A higher NPL ratio suggests more bad loans and potential losses. As of Q2 2024, Bank of America's NPL ratio is around 0.52%, which is low compared to industry standards and reflects high loan quality.

The third ratio is the provision coverage ratio, which compares the funds set aside for bad loans to the amount of non-performing loans, showing how well the bank is prepared for potential losses. A higher ratio indicates a more cautious approach to potential loan losses. Bank of America's provision coverage ratio in Q2 2024 is about 240%, suggesting it has ample reserves to cover potential loan losses, indicating overall financial stability.

For upcoming financial reports, monitoring Bank of America's CET1 Capital Ratio, NPL Ratio, and Provision Coverage Ratio will be important. Sustained low financial risk metrics would indicate continued stability, while deteriorations in these indicators might warrant caution.

3. Shareholder returns

While Bank of America's overall performance may not attract growth-focused investors, it can still be appealing from a shareholder return perspective.

Shareholder returns typically come in two forms: dividends and share buybacks. Dividends provide direct income to shareholders, while buybacks can enhance earnings per share (EPS), return on equity (ROE), and market liquidity, making them highly attractive.

Compared to many other U.S. companies, Bank of America has been quite generous with shareholder returns. From 2013 to 2023, the bank paid out approximately $63.7 billion in dividends and executed about $115.2 billion in buybacks. This amounts to a total of $178.9 billion returned to shareholders, which is 85% of the $211.7 billion in net income earned during that period—a commendable ratio in the U.S. market.

However, in 2022 and 2023, this ratio dropped to 50%, a significant decline from the over-100% levels seen in previous years. Fortunately, in the first half of 2024, the ratio rebounded to around 85%. Going forward, it will be important to monitor whether the company can maintain high levels of dividends and buybacks to ensure stable shareholder returns.

Having read this far, you may now have a deeper understanding of how to interpret Bank of America's financial reports. It's noteworthy that the release of earnings reports from prominent companies may present unique trading opportunities for different types of investors.

For instance, if an investor, after analyzing past reports and considering recent developments, believes a company's latest earnings will send positive signals and boost the short-term stock price, they might consider taking a long position. This could involve buying the underlying stock or purchasing call options.

Conversely, if the investor expects the earnings to be unfavorable and potentially pressure the stock price, they might consider taking a short position, either through short selling or buying put options.

If the report's outcome is unclear but volatility is expected, they might use a straddle strategy, buying both calls and puts.

However, investors should carefully assess their risk tolerance, particularly when considering high-risk trades like short selling or options, before making any trading decisions.

Summary

When analyzing Bank of America's financial reports, three key areas deserve attention:

1. Earnings Stability: The bank's revenue has shown minor fluctuations, and net profit has been relatively stable in recent years. The focus should be on whether the bank can maintain long-term stability, especially in the face of interest rate cuts.

2. Risk Indicators: Monitoring the CET1 Capital Ratio, NPL Ratio, and Provision Coverage Ratio will be crucial to ensure the bank maintains its historically stable risk profile.

3. Shareholder Returns: Historically, Bank of America has offered high returns through dividends and buybacks. Observing whether the bank can continue this trend will be key for assessing the attractiveness of its stock from a shareholder return perspective.