Big Upside Potential for Bank of America

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

An investment in Bank of America (NYSE: BAC) requires a contrarian mindset. The company has lagged its peers when it comes to cleaning up its balance sheet, and is still considerably exposed to regulatory risks and litigations. On the other hand, the stock is dirt cheap, and things seem to be turning for the better at this gigantic financial institution. It looks like the worse may be over for Bank of America, and at current levels there is a lot of upside potential in the stock.

Ugly and Cheap

Among big US banks, Bank of America is the one who got hit the hardest during the 2008/2009 crisis. In a very aggressive and expensive mistake, the company bought mortgage lender Countrywide for $4.1 billion in 2008. This added lots of toxic assets to the company's balance sheet and exposed Bank of America to billions of dollars in potential legal liabilities.

The chart compares ROE –Return on Equity – ratios for Bank of America versus competitors like Citigroup (NYSE: C), JPMorgan (NYSE: JPM), Wells Fargo (NYSE: WFC) and US Bancorp (NYSE: USB). The data shows that Bank of America is clearly behind its peers when it comes to recovering profitability, and legal uncertainties will likely continue being a headwind for the bank in the middle term.

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On the other hand, that's already reflected in the company's valuation. At a Price to Book Value of 0.46 Bank of America is the cheapest one in the group, trading also at a big discount to its historical valuation. Shares of Bank of America could even double in price from current levels, and they wouldn’t be excessively expensive in comparison to long term average valuation levels.

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The Right Timing

There is a reason why Bank of America is trading at less than half its book value, and it has to do with the many uncertainties surrounding the quality of its assets. The company is so big and complex that making a precise assessment about its financial health is almost impossible, but the data is pointing in the right direction. Slowly but steadily, Bank of America is streamlining its balance sheet in a material way, the last quarter showed a solid reduction in provisions for credit losses of 48%.

And some macroeconomic variables are providing a much appreciated tailwind for the company. The real estate sector is finally in a recovery, and this could have a big impact on the bank's profitability over the next years. The American consumer has been reducing debt over the last years, so clients are now in much better financial shape than during the times of the credit bubble. Unless the economy turns for the worse and we enter a new recession, Bank of America will likely see material improvements coming from the economic environment in the middle term.

One big issue to follow closely is the possibility of a dividend increase. Such a decision would require approval from the Federal Reserve, and it would be a clear sign on the fact than the worst is over for Bank of America. A raising dividend could be an important catalyst for the stock, as it would signal that the bank has finally turned the corner.

On Risk and Return

A position in Bank of America is a seriously risky one, legal problems are a material concern, and the company is very exposed to the economic cycle. However, there is a lot of upside potential at current levels, and things are looking better from both an economic perspective and in terms of balance sheet quality. For long term investors with a high risk tolerance, the size of the opportunity in Bank of America outweighs the risks.

acardenal has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, Citigroup Inc , JPMorgan Chase & Co., and Wells Fargo & Company. Motley Fool newsletter services recommend Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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