Thursday, July 12, 2012

Wells Fargo to Report Quarterly Earnings

Wells Fargo (WFC) will report its results for the 2nd quarter tomorrow morning. 

In this previous post, I mentioned there were two articles that spoke favorably about the strengths of Wells Fargo among the larger banks.

Invest Long-term, Ignore the Coin Flips

While really not all that surprising, both articles focused more or less on the near term implications of what they perceived as Wells Fargo's strengths. As I've said, I'm not a big fan of attempting to judge how well a stock or a business will perform in such a short time frame. It's just not really where energy is all that well spent in my view.

What I am interested in (and hopeful for) when Wells Fargo reports is evidence that management is taking actions that will build real long-term intrinsic value. Also, since even the best bank is vulnerable to systemic shocks and instability, I'm interested in the ways they are enhancing the bank's ability to withstand the inevitable tougher economic times and potential systemic stresses brought on by crisis. That's always of some considerable interest with any large relatively complex financial institution. It goes beyond just having a strong capital position.

Have they funding themselves in a fundamentally stable and sound manner and especially with an eye toward withstanding times of economic and financial system strain? In the important ways, are they strengthening their franchise relative to competition? Are deposits among the lowest cost in the industry? How well are they squeezing out other non-productive costs? Do they have robust credit standards and a culture with incentives that reinforce those standards? Are they continuing to develop an increased level of depth to their customer relationships over time (Wells Fargo's cross-selling culture)? 

Wells Fargo has a substantially higher net interest margin compared to the other big banks. That's not a small advantage when it comes to having both a greater ability to absorb losses during the tough times and to produce higher long run return on equity over a full business cycle.* Ultimately, that should lead to superior long-term shareholder returns at lower risk but says nothing about what the stock will do next week, month, year, or even longer. The economic tide will work both for them and against them from time to time but if they keep the cost of their money relatively low (and otherwise manage costs effectively), continue to mostly make intelligent loans to businesses and consumers, maintain/strengthen the balance sheet, and wisely allocate their excess capital, they'll create plenty of value over longer time frames.

Maintaining and increasing their competitive advantages will determine what Wells Fargo will be worth in 10 or 20 years. What's happening in next quarter or in the next several quarters reveals little in that regard.

Wells is a large bank that's less dependent on capital-markets-related revenue while the other larger banks generally do depend on capital markets activity as drivers of their core economics. More generally, Wells has a very strong domestic U.S. traditional banking franchise relative to its large peers (and does a rather small amount of investment banking business or proprietary trading).

So it's less of a casino and more trusted place for deposits and provider of credit to those that can use it and qualify for it. The kind of banking I'm thinking the world needs more of and needs it done well. All banks are vulnerable to systemic collapse but treating them if they are all the same is just an overly simplistic thing to do. Wells is still big and complex but how they primarily generate their revenues is very different from most of the other large banking franchises.

Banking seems difficult at best these days but the better run banks can use the current tough environment to increase the long run value of their franchise. Whether Wells beats earnings or revenue expectations this next quarter simply does not really matter that much.

I still wonder whether any bank is really worth the trouble for most investors considering the low valuations found among other investing alternatives. Sometimes what looks like a bargain bank stock is far from it. When it comes to investing in the common stock of banks, it's usually best to avoid what looks cheap. When it comes to the risk/reward profile, I'd favor the relatively understandable banks over the complex and opaque. In other words, banks primarily engaged in more traditional activities (being a trusted place for deposits and smart provider of credit...simpler, even if not exactly simple). Those with a strong balance sheet, smart expense management, low cost deposits, stable funding in most environments (insured deposits and long-term funding over short-term wholesale funding), who've proven they know how to intelligently provide credit to businesses and individuals that can handle it (rigorous credit risk management).

A bank with enough of the above characteristics will generally compound at a higher rate with lower risk than those that do not. They're sometimes worth what initially seems to be a premium valuation on a risk-adjusted return basis.

In contrast, those with a business model that depends heavily on capital markets and proprietary trading (stocks, bonds, currencies, commodities and their derivatives like credit default swaps etc.) to generate profits (and losses) are, to me, much less attractive than those who are providers of more traditional banking services. Most of these capital markets intensive institutions have -- all things being equal -- lower intrinsic value, more hard to gauge risks, and are deserving of what seems like a big discount.

As I said in the other post, Wells Fargo may or may not have great near-term business results. The stock may perform very well or horribly in the short run for all I know. I'll let others try to figure that out.

My thinking is that in the longer term the business and stock will do just fine.

Adam

Long position in Wells Fargo established at much lower than recent prices. No intention to add shares near the current valuation.

Consider that Wells Fargo has typically had a roughly 1% (and at times even greater) net interest margin advantage compared to other big banks. That may not sound like much but consider this: If Wells Fargo's net interest margin was more like its competitors (something like 1% lower...2.91% instead of the 3.91% in the 1st quarter of 2012), the bank would earn $ 11.3 billion less pretax! Here's another way to look at it. On the same amount of earning assets, the 1% net interest margin advantage enables Wells Fargo to absorb an additional $ 11.3 billion per year of losses before putting a dent in their capital (actually, first it would hit loan loss reserves then equity capital) during times of economic and/or financial stress. So there's a defensive angle to this advantage as well. Some may look at a bank more statically and give less weight to this important dynamic. 

Of course, the loans that go bad are accounted for with a provision for loan losses (a non-cash charge to earnings) that serves to build loan loss reserves on the balance sheet. Then, once a bank is convinced there's no hope of getting paid all or part of what is contractually obligated, loan charge-offs deplete the reserve. No matter how the accounting works, the important point here is that there is an additional $ 11.3 billion available per year to absorb losses on the same amount of earning assets. (Alternatively, a bank with a lower net interest margin needs to have more assets to generate the same amount of profit. Naturally, that means more loans that can go bad and must be absorbed.) 

Finally, a bank can have above average net interest margins but, if it tends to make a lot of dumb loans, at some point this extra capacity to absorb won't be enough. A bank still has to know how to put their money to work intelligently and that means consistently providing credit to borrowers who can actually handle it.
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