Published August 23rd, 2017 by Nick McCullum
The Bank of New York Mellon Corporation (BK) has been a holding in Warren Buffett’s investment portfolio since the third quarter of 2010.
Why is this important?
Well, Warren Buffett is arguably the best investor ever. He has grown his company, Berkshire Hathaway (BRK.A) (BRK.B), to a ~$444 billion market capitalization through years of sound business decisions and intelligent investing.
Accordingly, his investment portfolio is a great place to look for high-quality investment opportunities. You can see a full analysis of Warren Buffett’s investment portfolio here.
Among Warren Buffett’s investment portfolio, the Bank of New York Mellon Corporation – or BNY Mellon, for short – stands out because Buffett has been purchasing significant amounts of its stock over the past several quarters.
Don’t just take my word on it. Here’s the number of BNY Mellon shares owned by Berkshire Hathaway at the end of each of the last three quarters:
- Quarter ending 12/31/16: 21,671,969
- Quarter ending 3/31/17: 33,012,059 (52.3% increase)
- Quarter ending 6/30/17: 50,229,588 (51.2% increase)
Buffett has increased his BNY Mellon stake by ~52% during each of the last two quarters.
Clearly, something is special here.
This article will analyze BNY Mellon’s business model, growth prospects, and competitive advantages to determine why Warren Buffett is loading up on this stock.
Business Overview & Recent Financial Performance
The Bank of New York Mellon Corporation is a large, diversified financial services firm with a very globalized operating presence. The company serves more than 100 markets in 35 countries through an employee base of ~52,800.
BNY Mellon was formed on July 1, 2007 through the merger of the Bank of New York and the Mellon Corporation. Today, BNY Mellon is headquartered in New York and has a market capitalization of $56 billion.
On July 20, 2017, BNY Mellon reported financial results for the second quarter of fiscal 2017.
The company’s performance was very strong, posting 5% revenue growth and 17% earnings-per-share growth (both relative to the prior year’s period).
Moreover, BNY Mellon continued to be very profitable. The financial services firm saw a return on common equity of 10.4% (higher than many of its U.S. peers), which represented expansion of 110 basis points from the same period a year ago.
Source: BNY Mellon Second Quarter Earnings Presentation, slide 3
BNY Mellon continued to be a very shareholder-friendly capital allocator in the quarter.
The company returned more than $700 million to shareholders through share repurchases and dividend payments, and also executed a 26% increase to its quarter common stock dividend.
More importantly, BNY Mellon’s Comprehensive Capital Analysis and Review (“CCAR”) was approved by the Federal Reserve, which allowed the company to announce the intent to repurchase up to $3.1 billion of company stock over the next four quarters (which amounts to ~5.5% of the company’s market capitalization at current prices).
Source: BNY Mellon Second Quarter Earnings Presentation, slide 5
All said, the headline figure from this earnings release was the company’s 17% growth in adjusted earnings-per-share.
What drove this impressive growth in profitability?
Well, there were a number of contributing factors.
The company saw broad-based growth in investment services fees, net interest revenue (primarily thanks to rising interest rates), investment management and performance fees, and a continued execution of an internal cost-cutting program.
In addition, BNY Mellon benefited from rising assets under management (thanks to both contributions and rising asset prices) and net new business in its investment services business.
Additional performance drivers for BNY Mellon’s 2017 second quarter can be seen below.
Source: BNY Mellon Second Quarter Earnings Presentation, slide 6
All said, BNY Mellon’s second quarter delivered excellent performance for the company’s shareholders. The next section will discuss BNY Mellon’s long-term growth prospects in detail.
BNY Mellon’s near-term growth will likely be driven by rising interest rates.
The U.S. Federal Reserve hiked interest rates three times in the past 18 months or so, in the following months:
- December of 2015
- December of 2016
- March of 2017
Moreover, the Fed has communicated the intent to hike interest rates several times in the near future.
This will certainly benefit BNY Mellon, particularly if the current pace of rate hikes continues for several years.
In a rising rate environment, a financial institution like BNY Mellon can temporarily fix its deposit rates while raising its lending rates, resulting in higher net interest margin (NIM) for a finite period of time.
Rising interest rates cannot last forever.
Over longer periods of time, BNY Mellon’s growth will be driven by further expansion into international markets (the company currently has a presence in 100 markets across 35 countries) and the rising demand for sophisticated financial services. As a large player in the market, BNY Mellon is well-positioned to benefit from this second secular trend.
Competitive Advantage & Recession Performance
BNY Mellon’s competitive advantage comes from its size, scale, and entrenched presence in the highly-competitive U.S. financial services industry.
The company also has a well-known brand, which encourages more customers to do business with BNY Mellon simply because of its name recognition.
For context, BNY Mellon has $31.1 trillion of assets under custody or administration and $1.8 trillion of assets under investment management. It is hard to overstate BNY Mellon’s size-based competitive advantage relative to its peers.
With that said, BNY Mellon is far from a recession resistant investment. The company’s recession performance in the 2007-2009 financial crisis is evidence of BNY Mellon’s weakness to economic downturns:
- 2007 adjusted earnings-per-share: $2.18
- 2008 adjusted earnings-per-share: $1.20
- 2009 adjusted earnings-per-share: ($1.07) per-share loss
- 2010 adjusted earnings-per-share: $2.14
- 2011 adjusted earnings-per-share: $2.03
- 2012 adjusted earnings-per-share: $2.23 (all-time high)
BNY Mellon’s adjusted earnings-per-share plummeted during the 2007-2009 financial crisis, and the company also cut its dividend in fiscal 2009.
While this recession was particularly hard on the banks, that is no excuse for BNY Mellon’s terrible performance. This stock should not be purchased by investors that have downside protection as a primary investment objective.
Valuation & Expected Total Returns
One of the more attractive characteristics about an investment in BNY Mellon at current prices is the stock’s attractive valuation.
BNY Mellon is expected to report adjusted earnings-per-share of $3.55 in fiscal 2017 and the company’s stock currently trades at $52.78 for a price-to-earnings ratio of 14.9. For context, the S&P 500 is trading at a price-to-earnings ratio of about 24 right now.
With that said, BNY Mellon’s current valuation is above the stock’s typical trading range.
The following diagram compares BNY Mellon’s current valuation to its long-term historical average.
Source: Value Line
While BNY Mellon’s valuation is slightly above its average over the past 5 years, the company is certainly trading at a reasonable valuation. Buffett – the investor most famous for his focus on value – is purchasing this stock, which indicates that it is far from overvalued.
With that said, BNY Mellon’s valuation is not low enough to make valuation expansion one of the primary drivers of its future shareholders returns.
Instead, the stock’s performance will be driven by earnings growth.
We can estimate BNY Mellon’s potential for future earnings growth by looking at the stock’s historical growth in adjusted earnings-per-share (shown below).
Source: Value Line
Between 2010 and 2016, BNY Mellon has compounded its adjusted earnings-per-share at a rate of 6.7% per year. Looking ahead, it is likely that 4%-6% growth rate is feasible moving forward, negatively impacted by the company’s poor recession performance.
In the short-term, BNY Mellon’s earnings growth may be temporarily boosted by rising interest rates, but we believe this earnings estimate is a reasonable prediction for the company’s long-term performance.
Lastly, BNY Mellon’s performance will be boosted by the company’s dividend yield.
BNY Mellon currently pays a quarterly dividend of $0.24 which yields 1.8% on the company’s current stock price of $52.78.
BNY Mellon’s current yield is slightly below the ~2% average dividend yield in the S&P 500, but it is accompanied by a correspondingly low payout ratio (just 27% of 2017 estimates for adjusted earnings-per-share).
Importantly, BNY Mellon’s low payout ratio means that the company can continue increasing its dividend payments even if earnings stagnant for a short amount of time.
To conclude, BNY Mellon’s expected total returns will be composed of:
- 4%-6% adjusted earnings-per-share growth
- 1.8% dividend yield
For 5.8%-7.8% total returns before the impact of valuation expansion/contraction. In the short-term, performance may be superior to these estimates as the impact of rising interest rates are realized.
Warren Buffett has been a prodigious accumulator of BNY Mellon’s stock over the past several quarters.
On the surface, there isn’t any particular reason why. BNY Mellon’s recent financial performance has been excellent (17% earnings-per-share growth in the most recent quarter), but this is partially offset by a valuation that is higher than its long-term average.
It seems as though Buffett’s increased BNY Mellon stake might be a technique to benefit from rising interest rates. It nicely compliments Buffett’s far larger stakes in American Express (AXP) and Wells Fargo (WFC).
If you’re a believer in Warren Buffett’s investing acumen and would also like to benefit from rising interest rates, then an investment in BNY Mellon might be an attractive opportunity for you.
However, investors should be price-sensitive here.
The company’s valuation indicates that it might pull back to more attractive prices in the near future.