The fourth-largest U.S. bank by assets and the country's largest home mortgage lender, Wells Fargo (WFC), continues to attract considerable interest from investors and in particular Warren Buffett. During the third quarter 2012, Buffett's Berkshire Hathaway (BRK.A) bought another 11.5 million shares of Wells Fargo, increased its holding to almost 423 million shares, which is just over 8% of all shares outstanding. It is therefore clear that Buffett continues to like Wells Fargo, despite other investors and market pundits taking a more gloomy view of the banking sector as a whole. In this article, I have set out to analyze why Wells Fargo continues to be an attractive investment for Buffett, and whether it represents an appealing opportunity for investors. I have performed this analysis with a focus on comparing Wells Fargo to the three other major U.S. banks; JP Morgan (JPM), Citigroup (C) and Bank of America (BAC).
Financial performance continues to be strong despite economic headwinds
Wells Fargo continues to perform strongly, having exceeded the forecast consensus earnings per share (EPS) for the fourth sequential quarter, reporting for the third quarter EPS of 88 cents. This consistently strong financial performance is underpinned by the bank's growing revenue and net income, which has increased over the last five quarters as the chart below illustrates.
Source data: Wells Fargo Consolidated Statement of Income Third Quarter 2011 to Third Quarter 2012 & Federal Reserve Bank of St Louis.
For the third quarter 2012 the bank reported revenue of $21.2 billion, which is a 0.5% decrease in comparison to the previous quarter (QoQ), and an 8% increase in comparison to the same quarter in the previous year (YoY). For the same period, net income was reported as $4.9 billion, which is a 7% increase QoQ and a 22% increase YoY.
Consistent growth in revenue can be attributed to the bank being able to grow its loan portfolio, which grew by 1% QoQ and 3% YoY to $782.6 billion, as the chart below illustrates.
This rate of growth is lower than JP Morgan and Citigroup, which saw their loan portfolios grow by 3.6% and 3.3% respectively, but it is superior to Bank of America, which saw its loan portfolio by shrink by 5% YoY. It is also not the most spectacular rate of growth in the bank's core business of lending, but it is commensurate with its peers and I believe quite an achievement given the difficult economic environment.
Wells Fargo has also been able to grow its deposits over the last year to $952 billion, which is a 2.5% increase QoQ and 6% YoY, as the chart below illustrates.
Its YoY rate of growth is lower than Citigroup's 10%, but higher than JP Morgan's 4% and Bank of America's 2%. It is also higher than the rate of growth for Wells Fargo's loan portfolio for the same period. This indicates that the bank is focused on maintaining a high level of liquidity, and lowering its reliance upon wholesale credit to fund its lending operations. All of which contributes to a lower risk profile and stronger balance sheet for the bank.
Continues to maintain a fortress balance sheet
Wells Fargo continues to maintain a solid balance sheet, with a focus on controlling funding costs, while maintaining asset quality and liquidity, all of which is allowing the bank to maintain a high level of profitability. This is indicated by the bank's lower reliance upon wholesale credit to fund its business operations and lending activities, which can be seen by its long-term debt to equity ratio of 91% illustrated in the chart below.
This ratio is significantly lower than Citigroup, Bank of America or JP Morgan, and allows Wells Fargo to benefit from having a less volatile and lower cost funding mix. Since the occurrence of the Great Financial Crisis (GFC) and now the European financial crisis, global credit markets have become increasingly risk averse, which has seen the supply of wholesale funding decrease while costs have increased.
Liquidity continues to remain high
Another aspect of Wells Fargo's strong balance sheet is the bank's high level of liquidity as represented by its loan-to-deposit ratio. At the end of the third quarter Wells Fargo had a loan-to-deposit ratio of 82.2% which, as illustrated by the chart below, is marginally lower than Bank of America's but higher than either JP Morgan or Citigroup.
This loan-to-deposit ratio is lower than what is generally considered to be the optimal range of 95% to 105%. But in my view, this is a positive, because it leaves Wells Fargo better equipped to deal with any further financial shocks in an increasingly uncertain global and domestic economic environment.
Asset quality remains high
Another key indicator of the strength of a commercial bank's balance sheet and the degree of risk being carried by the bank is the quality of its assets, which in the case of a commercial bank are predominantly the loans made to customers. The quality of these loans is measured by the bank's non-performing loan ratio (NPL), which for Wells Fargo at the end of the third quarter was reported as 1.5% as illustrated by the chart below.
This NPL ratio is the second lowest of the four major U.S. banks, with only JP Morgan's NPL ratio of 1.1% being superior, and it is also less than half of the U.S. industrywide national NPL ratio of 3.7%. By having such a low NPL ratio Wells Fargo is able to minimize both the accounting and economic costs associated with having non-productive assets as well as the level of loan loss provisions it is carrying.
Another positive indicator of the health of Wells Fargo's balance sheet is the decline in loan loss provisions over the last year, with the bank reporting that loan loss provisions had fallen by 11% QoQ and YoY to $1.6 billion, as illustrated by the chart below.
Any significant and continued fall in provisions is particularly important for a bank's profitability, because provisions come with both an accounting cost and economic cost. This arises because not only must the bank incur a cost for holding the funds on their balance sheet, but they also cannot be used for revenue generating activities.
Capital adequacy remains well above minimum requirements
The GFC and the European financial crisis have seen a renewed focus by governments, regulators and investors on the capital adequacy of banks. This issue was brought to the fore earlier this year when four U.S. banks, including Citigroup, failed the Federal Reserve stress test, because they fell short of the minimum capital requirements. Passing the stress test is an important requirement for banks to obtain regulator permission to increase dividend payments, and/or return capital to shareholders by way of share buybacks. Wells Fargo passed that test and as a result was able to increase its dividend payment.
For the third quarter 2012, Wells Fargo reported a tier one common capital ratio of just over 10%, which as the chart below illustrates is the lowest of the four major banks.
The next stress test will be conducted by the Federal Reserve using third quarter 2012 results, with the outcomes to be made available in March 2013. The consensus view is that Wells Fargo, along with the other major banks will successfully pass the new Federal Reserve stress test. Wells Fargo should then return the majority of its 2013 net income to shareholders by way of dividends and share buybacks.
Efficiency and profitability continue to remain strong
While a fortress balance sheet may highlight the strength of a bank and the low degree of risk that an investor is undertaking when making an investment, it is how effectively a bank controls its costs and deploys its capital that determines its profitability. Wells Fargo, despite the economic headwinds and difficult operating environment, has been able to effectively identify gaps in the market and deploy its capital to become and maintain its position as the largest home mortgage lender in the U.S.
A key ratio that measures a bank's financial performance, and its ability to cost effectively generate revenue, is the efficiency ratio. Generally, the lower the ratio the more cost efficiently and productive a bank is at generating revenue, with a ratio of 50%, or lower, seen as optimal. But investors should recognize that the U.S. is a higher cost environment, with higher demands from customers for better service and greater degree of bank infrastructure, which increases their operational costs.
Wells Fargo's ongoing focus on cost control can be seen by its efficiency ratio of 57%, which is the lowest of the four major U.S. banks as illustrated by the chart below.
An efficiency ratio of 57% effectively means that Wells Fargo is spending 57 cents for every dollar of revenue that it generates. This is also lower than the average industrywide efficiency ratio of around 62% for U.S. banks, and a clear indication of why Wells Fargo has been able to maintain a solid level of profitability as evidenced by its double digit return-on-equity.
Another key indicator of a bank's profitability is its net-interest-margin (NIM); an indicator of the profitability of a bank's investing and lending activities over a given period. Just like conventional profit margins, the higher the margin the better. However, the extremely low interest rate environment that has existed in the U.S. since the GFC is placing considerable pressure on the NIMs of U.S banks, and therefore their profitability. This can be seen in the chart below, which shows that the industrywide NIM for the second quarter 2012 was just over 3.5%.
Source: Federal Reserve Economic Data (FRED), Federal Reserve Bank of St Louis.
Furthermore, with the Federal Reserve now having extended its zero interest rate policy into 2015, which will continue to place pressure on the NIMs of U.S. banks and subsequently their profitability.
However, despite this Wells Fargo continues to report a solid NIM, particularly in comparison to the other three major banks, which for the third quarter was just under 3.7% as the chart below illustrates.
Despite Wells Fargo's NIM declining in the third quarter and the renewed pressure on NIMs caused by the Federal Reserve extending its zero interest rate policy, I expect Wells Fargo to be able to maintain a solid NIM. I have taken this view because of the bank's strong focus on cost control coupled with its position as the largest home mortgage lender in the U.S., giving it the economic advantages that come with scale and possessing a large market share. I believe this is a key reason as to why the bank still remains profitable, particularly in comparison to the three other major banks.
Since the end of the GFC, the profitability of U.S. banks as represented by their return-on-equity, has fallen dramatically into single figures as the chart from the Federal Reserve Bank of St Louis shows below.
(click to enlarge)Source: Federal Reserve Economic Data (FRED), Federal Reserve Bank of St Louis.
For the second quarter of 2012, the industrywide average return-on-equity for U.S. banks was almost 9% and it has been in single figures since the end of the second quarter 2007.
However, Wells Fargo has consistently delivered a double digit return-on-equity since the second quarter 2010, and for the third quarter reported a return-on-equity of just over 13% which as the chart illustrates is superior to the three other major U.S. banks.
Given the bank's ability to consistently generate a higher than average NIM, along with its focus on cost control and its dominant position in the home mortgage market, I expect Wells Fargo to generate a solid return-on-equity for the foreseeable future. Furthermore, the banks strong balance sheet, high asset quality and falling loan loss provisions will further act to enhance its profitability.
Wells Fargo at this time pays a moderate but consistent dividend, which at the time of writing is 22 cents per quarter, with dividend payments for the year-to-date totaling 88 cents. This gives investors a handy trailing-twelve-month dividend yield of almost 3%. This yield is equivalent to that of JP Morgan but superior to both Citigroup and Bank of America, which currently pay nominal dividends with yields of 0.1% and 0.4% respectively.
Furthermore, Wells Fargo has consistently paid a quarterly dividend since 1995 as the chart below illustrates, and until the GFC this dividend was steadily increasing in value.
Even when the dividend cut that occurred at the time of the GFC is taken into account, Wells Fargo's dividend since 1995 has a compound annual growth rate of 8%. However, over the last ten years that has fallen to a compound annual growth rate of 3%, which is still higher than the rate of inflation. It is also highly likely that as the bank's financial results and capital position improves, it will continue to reward shareholders by increasing the dividend and/or returning capital through share buybacks.
Calculating Wells Fargo's indicative fair value
It is clear that Wells Fargo is the strongest performing of the four largest U.S. banks with a solid balance sheet, high asset quality, low costs and solid profitability. It maybe these attributes that continue to attract Buffett's interest in the bank, but given that his success has come from investing in high performing undervalued businesses, and I am intrigued as to whether the bank is currently undervalued by the market.
On initial impressions from reviewing the bank's valuation ratios in comparison to its peers it appears to be overvalued. This is because with a price to book value of 1.1 it is the only bank of the four U.S. majors, to be trading at a premium to its book value as the chart below shows.
However, Wells Fargo on the basis of its price-to-earnings ratio appears to be cheaper than either Citigroup or Bank of America but more expensive than JP Morgan. I don't believe it is possible to accurately value a bank using ratios alone, primarily because of the nature of the ratios and their simplistic and backward looking nature.
I have set out to determine Wells Fargo's indicative fair value using an excess return valuation, which is my preferred methodology for determining the fair value of a bank. To do this, I have calculated the bank's tangible book value as the starting point, and then used a range of assumptions based on the data presented above, to calculate an indicative fair value.
Wells Fargo has a tangible book value of around $133 billion, which equates to a tangible book value per share of almost $25. With the bank trading at around $32 at the time of writing, this indicates that it is trading at a 28% premium to its tangible book value per share. Using this tangible book value I have calculated Wells Fargo's retained earnings over a ten year period and then into perpetuity, using the following assumptions:
- I have discounted Wells Fargo's future return-on-equity over the valuation period to reflect both its future performance as a current value and to allow for further impacts from the current economic headwinds.
- For the above reasons when calculating the terminal value of the retained earnings I have used a discounted return-on-equity of 8% in perpetuity.
- Applied a conservative rate of economic growth of 2%, which is lower than the U.S. historical average of 3.4%, because it takes into account the long-term impact of the current global headwinds. It is also the same as the rate that I have used previously when applying the same methodology to value Bank of America, but lower than that used for Citigroup because of its higher exposure to faster growing emerging markets.
- I have applied a cost of equity of 7%, which was calculated using the capital asset pricing model (CAPM).
- I have assumed that the dividend payout ratio will remain steady for the duration of the valuation period, although if the payout ratio increased this would marginally reduce the indicative fair value.
Using this approach combined with the bank's tangible book value and assumptions listed, I have calculated an indicative fair value for Wells Fargo of around $39 per share as set out in the chart below.
At the time of writing Wells Fargo is trading at around $32, which means that this indicative valuation represents almost a 22% upside. While this does not represent a considerable margin of safety, it indicates that the market has moderately undervalued Wells Fargo and there is some opportunity for capital appreciation.
Other matters for consideration
There are a number of other matters that investors should consider when making an investment in Wells Fargo. The key risks and issues to consider are:
- The bank is still the subject of litigation across a number of matters relating to its conduct regarding the management of its mortgage portfolio, for the period of 2001 to 2010. In addition, there is further litigation that it has inherited through its purchase of Wachovia regarding various mortgage backed securities, bonds and notes that bank issued. Wells Fargo has estimated as at 30 September 2012 that its liability for probable and estimable losses is $1.2 billion.
- Wells Fargo has total exposure to Europe by way of securities, derivatives and loans of $27.8 billion, of which only $2.2 billion is to the high risk countries of Ireland, Italy and Spain. The bank, as of 30 September 2012, had no exposure to either Greece or Portugal.
- There is growing regulatory risk, with broad based regulatory changes on the agenda, which will increase regulatory costs, reduce opportunities for revenue generation and increase the economic cost of capital. All of which, will place further pressure on profitability. Banks are also seeing growing regulatory uncertainty with the Federal Reserve recently announcing that the introduction of the Basel III reforms will be delayed.
While it is difficult to judge the exact impact of these risks, I believe that any impact will be mitigated by the bank's continued efforts to reduce risk in the business and increase the quality of its assets.
It is clear there are many things to like about Wells Fargo, and I can see the attraction the bank holds for Buffett. It is a well-capitalized bank with a solid balance sheet composed of high quality assets and a relatively low amount of long-term debt. It has been able to expand its market share to become the largest U.S. home mortgage lender, while retaining a firm control of costs and still generate the highest NIM of any of the top four U.S. banks. All of which, has contributed to making Wells Fargo the most profitable of the top four banks.
Clearly, Buffett is attracted by the bank's robust franchise and fortress balance sheet combined with its consistent ability to cost effectively grow profitability in a difficult operating environment. On top of which Wells Fargo consistently continues to reward shareholders through a growing dividend payment and potential share buybacks. These are attributes that all investors should seek out when considering making an investment in any bank.
Furthermore, if the growing U.S. housing recovery continues to gain traction, it will act as a powerful tailwind and drive further growth for Wells Fargo as the largest U.S. home mortgage lender. I would also expect the bank to continue increasing the value of its dividend as its capital adequacy improves and allows it to meet the regulatory requirements for doing so. Furthermore, with the bank trading at a 22% discount to its fair value there is considerable opportunity for moderate capital appreciation. All of this, I believe, makes Wells Fargo a compelling investment for the long-term investor seeking a profitable, well-managed bank with a dominant market share that pays a consistent income stream.