Rarely do you get the chance to buy one of Berkshire Hathaway CEO Warren Buffett’s favorite stocks on sale. But that’s the case now with Wells Fargo.
Sure, the bank looks pretty bad following revelations of fraud that cost it $185 million in fines last September. In this scandal, Wells Fargo & Co. WFC, -0.19% staff opened up over two million phony deposit and credit card accounts to hit aggressive sales targets so they could earn bonuses.
That was dumb, and it just reinforced the rotten image people have of bankers.
But as bad as the scandal was for customers, investors should be thankful because it creates a discount for the bank’s stock, which is down about 10% since the beginning of March. The S&P 500 Index SPX, +0.76% has fallen about 1% in that same span.
“You have to have some overhang that gives you the opportunity to purchase a great franchise with best-in-class return on equity at significant discount against its peers,” says Colin McWey, a portfolio manager at Heartland Funds. Heartland has a significant WFC position purchased during the stock’s weakness last year.
Still, says McWey, some big questions loom. Chief among them: “What is the fallout with the brand, and is it so significant that it materially changes customer behavior in a way that precludes them from earning the superior returns?” The answer: “We think their profitability is going to stand the test of time. Over time, they are still going to be a top-tier bank,” says McWey.
He’s not the only one who thinks so. A starting point for me with most of the names I suggest in my stock newsletter, Brush Up on Stocks, is the right kind of insider buying. And that’s exactly what we have at Wells Fargo. At this bank, we have what I like to call “buying in size,” one of the key signals I look for to find the best insider buying signals.
CEO Tim Sloan and board chair Stephen Sanger recently bought $5 million worth of stock. Sloan bought $2 million worth and Sanger purchased $3 million. That’s the highest level of quarterly insider buying at Wells Fargo in at least five years. They purchased near current levels. So you can get close to the same price they got: $51.65.
Wells Fargo looks cheap
The two top insiders at the company were probably buying, in part, because the stock looks cheap. The discount is striking relative to other banks and Wells Fargo’s own history. It is also remarkable, given the bank’s solid profitability.
“The vast majority of banks are trading at the high end of their historical ranges,” says McWey, at Heartland Funds. But you can now buy Wells Fargo stock at a discount to its own historic range and the banking group in general. “That is unheard of,” he says. “It screams attractive.”
Here are some numbers. Wells Fargo currently goes for a forward price-to-earnings (P/E) ratio of 12. Its median over the past 20 years has been 13. The industry average right now is 13.6, according to Thomson Reuters. U.S. Bancorp USB, +1.99% has a forward P/E of 14.5. At Bank of America Corp. BAC, -0.04% the forward P/E is 13. And at J.P. Morgan Chase & Co. JPM, -0.06% it’s 12.5. The S&P 500 Index SPX, +0.76% has a forward P/E of 18.2. In addition, Wells Fargo’s trailing P/E of 13.2 is way below the industry average of 16.8.
All of this is remarkable given that Wells Fargo has a return on equity (ROE) of 12.6%, even after the scandal, compared with an industry average of 8.4%. “The bank that has a better ROE should have a better valuation,” says McWey.
Bogus valuation history?
One pushback here is that Wells Fargo’s relatively rich historical valuations and profitability are no longer meaningful. That’s because they were “bogus,” as they were base on fraud, suggested NAB Research analyst Nancy Bush during the bank’s most recent conference call. But this doesn’t really make sense to me. It’s hard to see how the creation of a bunch of fake accounts that customers never used could boost revenue or profits if they were inactive.
CEO Sloan also takes issue with this analysis. “I might just push back a little bit on the ‘bogus’ comment,” Sloan said during the call, “because that would indicate that our statements were materially inaccurate, and they weren’t.”
“If the bank is run properly, and I presume that is going to happen, there’s no reason it should not get back to its traditional valuation,” says bank analyst Chris Whalen of Whalen Global Advisors.
The business is holding up well
One of the major fears about Wells Fargo was that its storied brand will be permanently damaged by the scandal. Customers might flee, eroding the banks’ valuable low-cost source of funds gathered in deposit and checking accounts.
“But we’re not seeing major deposit flight,” says McWey. Indeed, customers are sticking around at a time when industry competition for their funds is picking up for the first time in almost a decade, because interest rates are finally going up.
Other metrics show the scandal is not hurting Wells Fargo’s reputation or business too much:
• Loan and deposit growth are “in sync” with the industry, says Credit Suisse analyst Susan Roth Katzke. “The growth in average consumer and small-business banking deposits has remained strong, up 6% from a year ago,” Sloan said in the most recent quarterly earnings call.
• Retail bank customer satisfaction scores are nearly back to levels before the fraud settlement was in the headlines last September.
• The decline in customer “interactions” with branches has slowed. Online interactions are up 8% from a year ago. Overall customer attrition rates are back down to pre-settlement levels.
• In March, the company saw its second month-over-month increase in checking accounts. Consumer credit card applications increased 10% compared with February, the largest month-over-month increase since September.
• The value of customer assets made in referrals from community banks to Wells Fargo’s investment management side are back up to $1 billion a month, around the levels seen before the settlement.
• Employee turnover is down.
“The business itself is still very solid,” says Whalen, of Whalen Global Advisors. He predicts it will continue to improve. “They will get back on their game. It’s a great franchise. It’s a tarnished name at the moment, but that’s going to be forgotten soon if management can stay out of the headlines. You give this thing five or six months, and all will be forgiven.”
“As we get further away from the events, client confidence should improve and their operating metrics should benefit,” agrees Macrae Sykes, a bank sector analyst at Gabelli & Co.
Wells Fargo, the non-Wall Street bank
One of the long-standing positives for Wells Fargo investors is that its core business is retail and small-business banking. It does very little business in trading, and mergers and acquisitions. That’s good, because these kinds of businesses can hurt shareholders. Goldman Sachs Group Inc. GS, -0.01% shares declined a lot recently when performance was hit by weak trading revenue.
“Wells Fargo doesn’t have the Wall Street risk. They don’t live and die on mergers and acquisitions, and trading,” says Whalen. “That’s why Warren Buffett likes it.”
There are risks, though.
• One is more shoes to drop in the scandal. “There is uncertainty about how long these investigations will go on, including potential for criminal referrals,” says J.P. Morgan analyst Vivek Juneja, who has a “neutral” rating on the stock. “Longer term, we expect management to turn this around.” But the timing is uncertain, he says.
In a worst-case scenario, the scandal and ongoing investigations permanently damage the brand. “The company is not going to fail. But this takes some of the respect away. It tends to infect the whole company, and it takes them a long time to pull out of it,” says Dave Ellison, portfolio manager of the Hennessy Large Cap Financial Fund HLFNX, +0.16% “You say, ‘OK they are no better than anyone else, and they’ve really shown it.’ ”
• In part because of the costs related to the scandal, Wells Fargo’s efficiency ratio (non-interest expenses divided by revenue) recently shot up to 63%, compared with a more normal level in the mid- to upper-50% range. But the bank is working on cost cutting, and investors should hear more details at an investor day in May.
• Another problem is the recent slowdown in bank loan growth, and the delays in expected tax and regulatory reform proposed by President Trump, says Baird analyst David George. If the lack of progress on reform continues, 2018 bank earnings estimates look high, he says.
Whalen thinks bank stocks could fall another 10%-15% in the ongoing retrace of the “Trump bump” in banking names. Wells Fargo would get caught up in this. But it might fall less because it rose less than other banks after the election.
One thing you don’t need to worry about is the ongoing Buffett selling. He’s recently sold close to 10 million shares. But that’s just because he wants to stay under a 10% position, for regulatory reasons. Buffett still owns about 491 million shares, or $25.6 billion worth. Wells Fargo is still a favorite investment.
Previously Posted On Market Watch