Banking on Survival of the Fattest

Bank of America (BAC) has long been better at expanding its reach than its stock price. Assets have swelled ninefold since 1996, but the shares are cheaper now. To be fair, that is partly the result of a financial implosion that has robbed the stock of 47% of its value in a year. But it is also because the Charlotte, N.C., acquisition machine has a history of paying too much to get big.

Five years ago I compared its purchase of FleetBoston Financial to a fat kid hopping on a see-saw. Bank of America's stock sagged 10% the day the deal was announced while Fleet's shot 23% higher. Whatever strategic value Fleet brought, investors clearly viewed the deal's financial benefits as one-sided. I took the opportunity to recommend Bank of America's shares. My reasoning: That deal gave the combined company a 9.8% share of American savings deposits. Banks are forbidden from buying their way into anything greater than a 10% share. Take away Bank of America's ability to pay too much for competitors and the rest of the business, including a dominant consumer bank with heavy exposure to the nation's richest markets, looks promising.

It also looked cheap at the time, at less than 11 times earnings and, more importantly, with a 4.6% dividend yield. Readers who bought then did well, at least for a while. Shares returned 24% including dividends, double the S&P 500 index's return, over the next year. Over three years they returned 60%. Of course, readers who've held straight through have lost money. They're down 19%.

Consider again a purchase of the stock, for two reasons. First, it's once again cheap, even considering how profits have cratered of late. Earnings per share this year are expected to total just $1.55, less than half last year's take of $3.30. That puts the stock at 15 times earnings, which would be a bit too much to pay for a big bank if earnings were expected to merely resume normal growth from this year's base. Wall Street foresees them rebounding to $2.56 a share next year, though, putting the stock at just nine times 2009 earnings. If you're reluctant to put much faith in forecasts -- and you should be, since analysts have guessed wrong on earnings in each of the past four quarters by an average of more than 50% -- consider a more reliable measure of valuation, especially in bear markets. The dividend yield stands at 5.4%, about two percentage points more than the broad market pays.

Second, Bank of America is relatively strong. It has already halved its dividend and issued stock to bolster its capital ratios. While borrower delinquencies have crept up, deposits have also flowed in, as savers have migrated from wobbly banks. Bank of America is still buying financial companies, if not banks. It snapped up Countrywide Financial, a mortgage lender, and Merrill Lynch (MER), a broker, earlier this year. The integration of both might prove awkward in coming quarters, but at least management is shopping for complementary businesses at shattered valuations, rather than paying top dollar to add branches.

I won't go so far as to argue that Bank of America has good growth prospects. Its love of buyouts is evidence it doesn't. But it has excellent survival prospects, and banks that survive the current downturn will be left with less competition, wider profit margins and higher valuations once the world's capital markets return to health. Today's buyers seem likely to see a higher stock price years from now and seem sure to collect a generous flow of dividends until then.

Bank of America turned up on a recent search for companies with modest valuations, plenty of free cash flow and ample dividends. Have a look below at all six companies that made the cut if you like. Run the search anytime for yourself using SmartMoney's stock screener.