Bank of America Still a Favorite of Fund Managers

15 April 2011 - TheStreet.com - Robert Holmes

Bank of America's(BAC) first-quarter earnings results fell short of analysts' estimates due to mortgage woes. Investment managers aren't giving up on the U.S. bank stock yet.

Concerns over repurchases of soured mortgages, known as putbacks, have dogged Bank of America shares. While the S&P 500 has climbed more than 4% this year, Bank of America shares have underperformed, falling 1.6%. Today, the stock dropped more than 1% to $13.13. Bank of America reported a quarterly profit of 17 cents a share, falling well short of Wall Street's average target of 27 cents a share.

Fund managers such as Harry Rady say Bank of America is only treading water, held back by the continued uncertainty around the bank's credit portfolio and mortgage putbacks. Rady, who owns Bank of America in the Rady Opportunistic Value(ROVYX) along with several other funds, says investors should look past the quarterly numbers and understand Bank of America's real value as a long-term holding.

"The risk/reward profile of Bank of America is attractive," Rady said by phone Thursday from his San Diego office. "I would look at it as a compressed spring. If they can get this mortgage putback issue behind them, that spring could rocket this stock into the high $20s. Until that happens, I would suggest that it trades between $10 and $20."

During the first quarter, the mortgage pains were significant for the bank. Bank of America was forced to set aside $1 billion to cover possible requests to repurchase mortgage securities. That's nearly double the $526 million in the same quarter a year earlier, showing that the cloud of putbacks may continue to hang over Bank of America's shares.

However, most investors should be well aware of Bank of America's putback risk. Instead, Rady argues that investors would be wise to buy an institution for Bank of America at tangible book value, which is the estimate of the bank at liquidation values, because of how attractive the franchise name is once the bank can put its issues behind it.

"Any time you get an opportunity to buy a franchise -- something with the name 'Bank of America' -- for tangible book value, that's like buying a business for the cost of the tables and chairs," he says. "The downside is protected by the fact that we're buying it at tangible book value. The upside is that when they fix the credit problems, the putback issues and the economy recovers, they'll be rewarded for this valuable, irreplaceable franchise that exists."

Robert Pavlik, chief market strategist at Banyan Partners, is also a fan of Bank of America over the long term. Pavlik says he personally owns shares of Bank of America, understanding that it will take time for the bank to clean up the mortgage foreclosure situation.

"I could probably make better money now if I traded it," Pavlik acknowledges, "but this is an investment to put away in an IRA account and not look at it every day. Five years down the road, you'll see these stocks trading higher and you'll be happy with the return. If we didn't have this issue surrounding the way they process foreclosures, people would be all over this stock."

One reason Pavlik finds Bank of America attractive over a longer horizon is the expectations of rising interest rates. "The spreads that these companies are going to be able to capture by lending out money at a higher rate and borrowing at a lower rate," he says. "That's the place you want to be."

Rady agrees, explaining that if interest rates rise, the yield curve would remain steep and allow banks to continue to capitalize on the spread between lending and borrowing.

"For banks, it's just a spread game," he says. "It doesn't really matter what the actual numbers are as long as the spreads exist. In a rising rate environment, the yield curve is anticipating rates continuing to rise, and that means a steep yield curve. As long as the yield curve steep, it doesn't matter how much rates rise. It certainly matters to the economy, but the bigger issues are credit and the mortgage putback issue."

Other money managers are even more bullish on Bank of America's prospects. Cliff Hoover, manager of the Dreman High Opportunity Fund(DRLRX), which owns a stake in Bank of America, says the stock is one of the most undervalued financials he has in the portfolio.

"Bank of America's retail and small-business footprint is second to none," Hoover says. "You're starting to see some commercial lending growth in the U.S. There are improved credit metrics. Capital is strong within Bank of America and they're building excess capital."

Hoover says that individual investors are waiting for a "magic catalyst" before they step in to buy Bank of America shares. He says investors would be better off looking at normalized earnings for the bank the way professional investors would. Hoover points out that banks generated massive return on equity (ROE) by using leverage leading up the financial crisis. Given the corrective period bank stocks endured, investors now need to normalize earnings, he says.

"To rationalize these banks going forward, we valued banks back to their traditional ROE levels, realizing that the leverage will go down," Hoover says. "The bedrock of our thesis is that Bank of America can easily generate a normalized earnings per share of about $3. With a price-to-earnings multiple of 10 on that, you get a $30 stock. That's not a really aggressive number."

In the wake of JPMorgan Chase's(JPM) lower first-quarter revenue and with questions of how Citigroup(C) will fare when it reports quarterly results on Monday, money managers say Bank of America might be worth looking at today as the stock moves on the report.

"At tangible book value, where it's trading right now, would it be logical to buy half a position at tangible book and if it gets cheaper they fill it out? Yeah, that's a logical strategy," Rady says. "It wouldn't be crazy to buy a full position. At these prices, any strategy is reasonable."