In our last article we covered the Bubble in “Safe” Stocks, where investors are paying outrageously high multiples for companies that are believed to be more recession resistant such as consumer staples. In this article I figured I’d cover a stock Mr. Market and the doom and gloom propagandists view to be “risky” based on current prices and sentiment. Any bank is perceived as risky right now it seems, despite some of the highest capital, liquidity, and earnings positions in their history, which tells you more about this environment than the actual companies.
2018 2019 2020 2021 2022
Net Income $18.045B $19.401B $11.047B $21.952B $14.845B
EPS $6.69 $8.04 $4.73 $10.14 $7.11
Tang BVPS $63.79 $70.39 $73.67 $79.41 $81.95
As you can see from the table above, this “risky” bank stock has averaged $17B in net income over the last 5 years and is on pace to do that again through the 1st quarter of 2023. Earnings per share have averaged $7.342 per annum. Tangible book value per share has grown materially every year, which has continued through the 1st quarter of 2023. Despite all these positive factors, the stock trades at an outrageously cheap market cap of $90.56B, and just 6.33x average earnings per share, or about 55% of tangible book value. Business is fantastic and the company is exceeding its return targets, but the stock price has been hammered the last two months due to a massive panic in bank/real estate stocks that has pervaded since the March 6th collapse of the very weak SVB Financial. The dividend is nearly 4.5% at current prices and we have covered calls at various levels, but this is a stock that could realistically double from the current price and would still not be expensive, trading right around my projected 2024 projected tangible book value per share. I could show you a similar picture for just about every financial stock in our portfolio, as all of them have in excess of 50% upside potential from current levels in our estimation.
All we need to be successful in these investments is for the entire U.S. financial system not to blow up completely. The earnings and asset values are there for everyone to see. Liquidity and deposits are extremely healthy, as are capital levels. Not every bank is in this great of a position of course, which is why we don’t own those weaker names that you keep hearing in the headlines, but just about every bank is being painted with the same brush in the current panic. Fear causes the market to price securities at ridiculous prices and that is what you are seeing right now, as there is absolutely no relation between current prices and intrinsic value on stocks such as Citigroup or ALLY for instance. We have seen these types of disconnects before in 2011, 2016, 2018 and 2020, and they usually resolve themselves in the next 6-12 months or so, if not earlier. We were very successful coming out of all those panic-driven manias non-coincidentally, and I fully expect that to be the case again here.
I believe it is far riskier owning a consumer staples company at double its normalized valuation with very little growth prospects, then owning these stocks at massive discounts to a conservative approximation of liquidation value, and earnings yields between 14-20%, with dividends from 4-8%. These are truly exceptional prices. Even stocks such as Microsoft had a lost 12-13 years, when investors had paid too high of prices for them in the Tech Bubble and I believe we might be seeing a similar dynamic in today’s so-called “safe stocks.” McDonalds trades at 32x earnings, when historically it has traded around 18-19. A reversion to the mean would put the stock at around $170 per share, from its current $296.66, or roughly 42% lower. A reversion to the mean for Citigroup would put the stock at over $70 per share, or about 52% higher. Obviously, there is risk in all investing and nothing is guaranteed but I believe the odds of success are stacked in our favor.
While the last two months have not been fun, we conservatively structured portfolios with options to where we are still above breakeven prices on many of our options, meaning if all the stocks were trading where they are now at expiration, I’d estimate a roughly 7-11% increase in account values through the combination of options decay and dividends/interest collected between now and January, putting us at solid near double-digit returns. If we get the upside I expect to achieve as the fear stabilizes, we could get high-double digits or more. I’ll give you an example of what I mean. We had sold much of our Bank of America stock in the high $30’s, or even $40’s the last few years. Most of these sales were from in-the-money covered calls being exercised. We still liked the business, but the price reached our estimate of intrinsic value, so we stayed true to our discipline and sold. To invest back again into the company, we sold puts at $28, which was far below the market price of BAC, which had been above $35 prior to March 6th, collecting a nice premium. Our target price for BAC is around $40 per share, so we are happy owning the stock at current levels. Our $28 January put options are currently selling for $2.90. If BAC, which currently trades at $27.66 in the midst of this major panic in bank stocks, trades above $28 at expiration, we will make $290 on a maximum risk of $2,510, which is an 11.55% return, or 16.7% annualized. If the stock expires below $28, we will end up owning BAC at a little over $25 per share and will have all the upside from there, which we believe to be around 50%. Hopefully this provides a little bit of context as I truly believe we are in a very great position moving forward, as our options, bond and stock positions mature.