You Don't Need to Worry About Bank Profits

Once again, all eyes are on Warren Buffett's portfolio...

Buffett recently unloaded around $7 billion worth of Bank of America (BAC) shares. And anytime a famous investor makes a big move like this, it's bound to make headlines.

Some folks are drawing a parallel between Buffett's sale and the Federal Reserve's recent rate cut. They're taking it as a sign that the banking sector has peaked.

But the story isn't that simple...

As we'll explain today, the banking sector is still holding steady – even with Buffett's big sale. Investors shouldn't hit the panic button just yet.

Yes, interest rates are falling, but banks can still turn a profit...

It's true – now that the Fed has begun cutting rates, banks will earn less on loans and deposits.

Lower interest rates squeeze a bank's margins, since they can't charge as much for the money they lend out. On top of that, their investments won't earn the higher rates they once did.

But here's the thing... rates aren't going back to zero overnight. The Fed's current rate remains over 5%. That's a stark contrast to the near-zero rates we saw during the pandemic.

Banks are still lending at favorable margins. Personal loan rates are often hovering around 7%. That leaves plenty of room for them to make money on new loans and deposits.

Just because rates are falling doesn't mean banks are out of the game. They're still operating in an environment that allows them to be profitable.

The current levels may not be as lucrative as the highs we've seen. But they're nowhere near low enough to signal trouble for the sector.

Buffett didn't buy Bank of America for short-term gains...

The "Oracle of Omaha" has always been in it for the long haul. He began investing in Bank of America during the Great Recession, when stocks across the sector were at rock bottom.

Some of his more recent investments date back to 2017, when the stock was still trading at nearly half of today's prices.

In other words, Buffett has been accumulating shares of Bank of America for more than a decade.

He's probably not selling because of short-term concerns over rates. After all, he has more than doubled his initial investment. At this point, it could be as simple as profit-taking or rebalancing his portfolio.

We can learn if investors should be worried by looking at Bank of America's pricing using Embedded Expectations Analysis ("EEA").

The EEA starts by looking at a company's current stock price. From there, we can calculate what the market expects from the company's future cash flows.

We then compare that with our own cash-flow projections.

In short, it tells us how well a company has to perform in the future to be worth what the market is paying for it today.

Bank of America's Uniform return on equity ("ROE") has remained solid over the years. The market expects it to stabilize around 10% through 2028.

Take a look...

Right now, investors expect Bank of America's Uniform ROE to start falling slightly. Equity growth is also expected to remain flat in the coming years.

The bank struggled thanks to the pandemic in 2020. But aside from that, Uniform ROE has been above 12% every year.

That was true even before the Fed started hiking interest rates.

Lower rates might mean banks need to get more creative to keep their profitability high. Bank of America has proved it can do that. Despite the rate cuts, it's still in a strong position to deliver solid returns.

It's tempting to read too much into Buffett's moves...

But the truth is, his decision to sell Bank of America shares doesn't point to an imminent banking crisis.

He's likely cashing in on gains after holding these shares for more than a decade.

Meanwhile, banks are still well-positioned to earn in today's environment. As long as rates stay well above historical lows, they'll continue to profit.

So while Buffett's sale is making headlines, you don't need to listen to them. There's no reason to panic over the future of banks.

Regards,

Joel Litman
October 1, 2024