Wells Fargo
Eagle Point Capital recently purchased shares of Wells Fargo for clients at $46 per share. Whenever we make an investment, we put our thesis down on paper. This makes learning from our successes and failures easier. We also wanted to start a blog and thought our Wells Fargo thesis would make a wonderful first post.
Wells Fargo is a company that needs no introduction. It’s a large money center bank that is almost universally reviled -- and for good reason. We don’t condone what Wells Fargo did. But we do think that negative sentiment has created an attractive investment opportunity.
Wells Fargo is an attractive investment because:
It’s a business we understand. This isn’t our first investment in Wells Fargo (we owned their TARP warrants for many years) or banks for that matter (we also own Bank of America and Southern Bancshares).
It’s a business which isn’t changing quickly. The first bank was founded by Giovanni Medici in 1397 in Florence. Banking has not changed meaningfully since. We know what Wells Fargo will look like in five or ten years.
Wells Fargo has a demonstrated and enduring competitive advantage -- an ability to consistently gather low cost deposits. Loans are commodities: borrowers take the lowest interest rate available. Banks, therefore, compete for loans on price. The only way to have an advantage when you compete on price is to be the lowest cost producer. Wells Fargo is. It earns 15% on tangible common equity despite low interest rates and an inverted yield curve.
Wells Fargo has a clear, low-risk, and accretive capital allocation strategy -- return all earnings and excess capital to owners. Wells Fargo’s 2019-2020 authorized payouts amount to a 16% yield at our cost basis ($46). This combines dividends and stock repurchases.
Wells Fargo is attractively valued at 10 times earnings. This is 10-20% cheaper than peers Bank of America and JPMorgan, and over 50% cheaper than the S&P 500 at 22x. Historically Wells Fargo has traded for 13 to 14 times earnings. We expect it to trade there once the Fed removes its growth restriction. So, in addition to a 16% shareholder yield, we think the stock could rise 30-40% as it returns to its historical trading multiple.
Wells Fargo is almost universally reviled, but not for financial reasons. Sentiment has shifted decisively against the company, yet the business continues to perform. Shares declined 33% from their all time high in January 2018 to their low in May 2019 while earnings per share grew 10%. This is a testament to how entrenched and sticky Wells Fargo’s business is -- people rarely move their accounts.
Additionally, investors seem to be wary of investing in banks after the financial crisis. We have no idea when the next recession will come. Afterall, Australia hasn’t had a recession in nearly 30 years. What we do know is that Wells Fargo is well capitalized with a CET1 ratio (tier 1 common equity) of 12.0% versus a regulatory requirement of 4.5%. Wells Fargo, like the rest of the U.S. banking system, is much stronger today than it was in 2006 or 2007.
It’s also little known or appreciated that Wells Fargo did not lose money during the financial crisis (see below, blue). In fact, I have 50 Wells Fargo annual reports (1969 to 2018) and none show a loss.
Wells Fargo is a compounding machine. Net income (above, blue) has compounded at 14% annually since 1968. Deposits (above, red) have compounded at 12%. Collecting low-cost deposits and lending them conservatively may not be sexy, but it sure is profitable.
Deposit growth is unlikely to be as rapid in the future as the past, since the Fed prohibits banks with 10%+ market share from making acquisitions. But, thanks to inflation, there are always more deposits to collect. The U.S. banking system’s deposit growth (below) is one of the most consistent and relentless financial trends -- total deposits have not declined year-over-year since 1948.
Inflation makes deposit growth across the entire U.S. banking system is virtually certain. Wells Fargo’s entrenched market share means it’s likely to capture a meaningful amount of that growth.
Wells Fargo will return to growth. Wells Fargo growth is valuable because it earns 15% on tangible common equity: every $100 it invests earns $15. The Federal Reserve temporarily banned Wells Fargo from growing its balance sheet as punishment for its accounts scandal. The key word is temporary.
This could end up being a blessing in disguise. Since Wells cannot grow its loan book, it’s likely to focus on increasing their loan book’s quality. This could make them even more resilient in the next downturn.
The foundation of our philosophy is to think and act like long term business owners. Accordingly, we care primarily about the price we pay and the cash flows we receive. On this basis, we feel that Wells Fargo is a sound investment at $46 per share.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.