Tuesday, August 3, 2010

The Wells Advantage

Bank stocks are tough to evaluate. Look at the 10-K of a large bank versus something like Rocky Mountain Chocolate Factory (RMCF). If that doesn't convince you to never invest in a bank I don't know what will.
(BTW: I am saying this as a long-term investor in Wells Fargo.)

One important factor for all banks is net interest margin (the spread between funding costs & the yield it earns on assets). A bank with greater net interest margin will, all things being equal, have superior return on equity (ROE) and a greater ability to absorb credit losses in periods of economic stress.

There is a good chart in this Wall Street Journal article that shows the significant net interest margin advantage Wells Fargo (WFC) has over other banks.

Net Interest Margin
Wells Fargo: 4.38%
Citigroup (C): 3.15%
J.P. Morgan Chase (JPM): 3.06%
Bank of America (BAC): 2.77%

To simplify, if two banks happened to have $ 1 trillion in assets and similar asset quality, the bank with a 1.2% net interest margin advantage would earn $ 12 billion/year (.012 times $1,000,000,000,000) more pre-tax, pre-provision for losses than its competitors. Again, all things being equal (In reality each of the 4 large banks have unique risks, strengths and weaknesses). That extra $12 billion/year can either go to the bottom line after tax during the good times (building capital) or absorb $ 12 billion more pre-tax* losses than its competitors during bad times (enhancing durability).

Now, from the above chart you can see that this kind of advantage is not far fetched as Wells has at least that much advantage in net interest margin over the three other banks. From the WSJ article:

Wells's cheap funding stems from its large, sticky deposit base.

Wells can absorb significantly more in losses as a % of its assets before going into the red. Over an economic cycle, those cheap funding costs, better yielding assets, and resulting higher net interest margin should allow Wells to:
  • Generate an after tax ROE in the high teens while its competitors earn an ROE in the low teens
  • Have a much greater ability to remain profitable during times of economic stress
  • Use its greater earning capacity to provide a buffer against needing more capital
The "photograph" of a banks balance sheet in 1 or 2 quarters or simple and static measures like tangible common equity (TCE), the measurement du jour during the panic, doesn't tell the story. It's how the "movie" plays out over a full economic cycle that does. During the crisis many analysts and pundits ignored this difference. In fact, quite a few do to this day. Warren Buffett had the following to say in Fortune back in April of 2009.

"You don't make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on."

He then added...

"...that deposit base I guarantee you will cost Wells a lot less than it cost Wachovia. And they'll put out the money differently."

As Buffett also pointed out last year, part of the Wells advantage comes from the simple fact that Wells Fargo runs its bank in a way that provides it with relatively lower cost of funding. Here's what he said to CNBC back in May of 2009:

"Wells Fargo obtains their money, which is the raw material, they obtain their money cheaper than anybody else...If you're a copper producer, and copper is selling for two dollars a pound, and you want to measure the stress of copper going to $1.30, for a guy whose production cost is $1.50, you know, he's got problems. If his cost is a dollar, he doesn't have problems. And Wells, in terms of its raw material costs, is better situated than any large bank, by some margin. So, it's built to sustain a lot."

Ultimately, Wells Fargo was required to raise capital after the stress tests.**

From this Bloomberg article:

"I think I know their future, frankly, better than somebody that comes in to take a look," Buffett said yesterday of the bank stocks that Omaha, Nebraska-based Berkshire owns. Regulators, "may be using more of a checklist-type approach."

Buffett Dismisses Government Stress Tests

Buffett said the above things when most analysts were downgrading the stock.

Price targets for the stock were being lowered to single digits.

The results of the stress tests did require Wells Fargo to raise capital, but it seems clear now that the assumptions in the test underestimated the bank's capacity to generate revenues and earnings.

In the end, I think those who look at Wells Fargo's persistently superior revenue generation and earnings power objectively, it's rather clear that Buffett was right.

I first mentioned Wells Fargo as a stock I like*** here on April 9th, 2009 when it was selling for less than $ 20/share. The capital raising certainly did not help shareholders, but the stock is selling at $ 28 now and -- short of another forced capital raise -- should see some nice increases to per share intrinsic value over the long haul.

Right now, Wells is still working through the integration and repair of Wachovia post-acquisition, but over time have proven that they are rather good at banking. As they come to grips with the Wachovia challenges, it should become an increasingly valuable part of this banking franchise.


Long RMCF, WFC, C, and BAC

* Pre-tax because a business, bank or otherwise, can absorb losses on a pre-tax basis.
** In my opinion, Wells Fargo did not need to raise more capital after the stress test. They had lower tangible common equity due to the acquisition of Wachovia but the stress tests underestimated Wells's capacity to generate revenues and higher returns relative to its competitors. The quarters that have gone by since the test have confirmed this. While it may not have been fair to Wells Fargo I happen to still think it was the right thing to do for overall financial system integrity. Such is the nature of investing in banks. The risk is always there that regulators will force some dilution on the existing equity holders for the greater good of the system.
*** This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.