Despite the stormy environment, this Warren Buffett stock has an utterly rosy outlook

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Legendary investor Warren Buffett and his company, Berkshire Hathaway (BRK.A 3.19%) (BRK.B 3.28%)really bet everything Bank of America (BAC 3.71%)the second largest bank in the United States by assets.

The conglomerate owns more than a billion shares of Bank of America, equivalent to 12.9% of outstanding shares. The stock is also now the second-largest position in Berkshire’s equity portfolio of around $324 billion, accounting for nearly 11% of the total.

While the stock has sold off this year amid fears of a deep recession in 2023, Bank of America’s earnings outlook is really pretty rosy right now. Here’s why.

Operating leverage

Operating leverage is a key metric bank investors look for, and it’s really great for any business because it simply means revenue is growing at a faster rate than expenses. After the third quarter, Bank of America has now generated five consecutive quarters of operating leverage thanks to a few different factors.

Image source: The Motley Fool.

First, net interest income (NII), the profits banks earn on loans and securities after funding those assets, has surged in the high interest rate environment. Higher rates translate into higher yields on many bank loans and bond holdings, which can lead to widening bank margins if the bank can keep deposit costs from rising too high.

In the third quarter, Bank of America delivered $13.8 billion of NII, up $1.4 billion from the second quarter, which was higher than management’s initial forecast. Management expects the NII to rise by at least another $1.25 billion in the fourth quarter if the Federal Reserve’s planned interest rate hikes materialize, and management also believes it will possible to continue to increase the NII in 2023.

On the other side of the operating leverage equation, Bank of America has done a good job of managing expenses. The bank expects only minimal spending growth for the year 2022 compared to 2021, which is quite impressive when you consider the inflationary pressures this year.

Also, it looks like Bank of America is only forecasting low-single digit spending growth next year, which is also very minimal. If NII continues to grow like gangbusters and expense growth is minimal, there’s a very good chance that operational leverage will continue into next year.

Strong capital position

Faced with higher capital requirements at the start of the quarter, Bank of America reacted quickly and is now in a strong position.

After annual stress tests by the Fed, Bank of America learned that the amount of regulatory capital it would need to hold as a percentage of its risk-weighted assets (RWA), such as loans, would increase. This meant the bank would need to build up capital, leading many investors to wonder what the prospects for share buybacks might be.

But the bank produced a strong net profit in the third quarter, which boosted capital and also reduced its RWA. By the end of the period, Bank of America had built up significant headroom on its new capital requirements. Strong earnings coupled with higher capital levels allowed the bank to repurchase $450 million of shares in the third quarter, and management expects repurchases to increase.

Additionally, credit quality remains extraordinarily clean at this time. Bank of America’s loan loss provision is currently six times the level of probable loan losses bank expected in the third quarter.

Buffett knows how to choose them

There’s obviously a lot of uncertainty right now, and the economy could officially be in recession in 2023, but Bank of America’s earnings are currently expected to grow satisfactorily next year.

Credit quality is still very good and Bank of America is managing its spending well, with a robust NII. The bank is also likely to maintain a strong capital position that allows it to continue buying back shares.

That’s likely one of the reasons Berkshire increased its stake in the company early in the pandemic as it sold other bank stocks. Bank of America benefits from higher interest rates and has the ability to navigate a difficult environment, which is why I think its outlook is still quite rosy.

Bank of America is an advertising partner of The Ascent, a Motley Fool company. Bram Berkowitz holds positions at Bank of America. The Motley Fool holds positions and recommends Berkshire Hathaway (B shares). The Motley Fool recommends the following options: $200 long calls in January 2023 on Berkshire Hathaway (B shares), $200 short puts in January 2023 on Berkshire Hathaway (B shares) and short calls of $265 in January 2023 on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.

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