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Introduction

Wells Fargo & Company (NYSE:WFC) is a great investment going into 2013 due to recovery in its lending businesses, growth in its fees, improving economic conditions, along with added certainty in the regulatory environment. Investors should buy Wells Fargo because of information arbitrage.

Qualitative Analysis

Source: Information pertaining to Wells Fargo came from the shareholder annual report, with additional information from the quarterly report, investor presentation and the JP Morgan Chase annual report.

Wells Fargo operates in three operating segments: Community banking, wholesale banking, and wealth/brokerage/retirement.

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Wells Fargo operates a diversified business model, but its fastest growing division is the non-interest income (fee income).

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The fee income grew by 16% over 4Q 2011, fees represents 52% of revenue, and will contribute to a large percentage of the company's growth going forward.

The Basel Committee on Banking Supervision has finalized the Basel III regulation for determining regulatory capital, and when fully phased in by 2019, will require a tier 1 common equity to risk-weighted assets of at least 7.0% for small banks. For bigger banks the equity to risk-weighted assets will be 8-10.5%.

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Wells Fargo is on its way to meeting the capital requirements imposed for globally systematically important banks (G-SIBs). The Basel III requires 7% plus an additional 3-3.5% in Tier 1 common equity capital totaling 10-10.5% for common equity by 2019 for systematically important banks like Wells Fargo. Wells Fargo is well within range at 10.12%, and is likely to meet its capital requirements by 2019.

Wells Fargo anticipates that it can generate higher yields and returns for investors by cross-selling more financial products. Its 2011 cross sell rate was 5.92, and it anticipates that it will be able to increase the cross-sell rate. The average household has between 14 and 16 financial products. This implies that Wells Fargo roughly sells half the financial products an average household uses, and plans to increase market share and revenues through cross-selling.

Wells Fargo's cross-selling strategy is likely to succeed because banking and insurance services are inelastic. The elasticity rating for banking and insurance services is 0.56. A lower elastic rating implies that the company will rely on brand value, relationship building to win customers. Customers are less price-sensitive to financial services, so it is the non-intrinsic aspects of the business that generates added banking clientele. This is why banks rely heavily on marketing, excellent customer support, and customer satisfaction ratings. Wells Fargo's brand (intellectual property) can be assumed to be worth $10-$100 billion based on its balance sheet category titled "other assets."

Many in the financial media have cited that the shadow inventory of houses would collapse any hopes of a long-term housing recovery, I think this is wrong. The American population has continued to grow by 3 million people a year. Population growth implies a demographic need for housing. Economists estimated that there is pent-up demand and that household formation will return to 1.2 million a year as job conditions continue to improve (unemployment rate is currently 7.9%). During 2011, only 845,000 housing units were built annually over the last four years, with demolition and destruction of homes from demolition, and natural disaster (Katrina, Sandy, etc.) resulted in a 250,000 decrease in the number of homes on average (4-year average). The growth of households are likely to absorb pre-existing housing supply; this implies growth in Wells Fargo's lending, and that new loans may be able to offset losses from its pre-existing lending portfolio.

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Wells Fargo anticipates lower loan losses going forward hence the reduction in allowances for loan losses. Based on the trend, it is likely that the amount lost on pre-existing mortgages will continue to decline.

The Wall Street Reform Act (Dodd-Frank) will result in higher deposits held by banks, and banks not being allowed to speculate using bank money. This may have an adverse effect on earnings going forward. On the positive, Wells Fargo has many upside catalysts going for it: declining loan loss allowances, improving economic conditions, rising demand for mortgages, along with double-digit earnings growth from fees.

Wells Fargo competes with Citigroup (NYSE:C), Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM), Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), Lloyds Banking (NYSE:LYG), HSBC Holdings (HBC), BlackRock (NYSE:BLK), Charles Schwab (NYSE:SCHW), UBS AG (NYSE:UBS), among many others.

Technical Analysis

Wells Fargo has been on a continuous uptrend since the March 2009 bottom. The technical analysis indicates that Wells Fargo is trading in an extremely tight range, but will have to make a major move by the end of 2013.

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Source: Chart from freestockcharts.com

The stock is trading above the 20-, 50-, and 200-Day Moving Average. The stock is in a confirmed uptrend (higher highs and higher lows), the uptrend further supports the buy thesis, and a confirmed break above the symmetrical triangle formation will cause the stock to experience a revival in valuation that will be unprecedented.

Notable support is $23.00, $30.00, and $31.50 per share. Notable resistance is $36.00, $37.80, and $44.60 per share.

Street Assessment

Analysts on a consensus basis have reasonable expectations for the company going forward.

Growth Est

WFC

Industry

Sector

S&P 500

Current Qtr.

16.00%

398.50%

-94.00%

9.10%

Next Qtr.

9.80%

105.20%

-92.80%

14.60%

This Year

7.10%

25.60%

22.30%

7.20%

Next Year

6.90%

10.10%

7.20%

12.80%

Past 5 Years (per annum)

11.31%

N/A

N/A

N/A

Next 5 Years (per annum)

9.54%

8.38%

10.64%

9.09%

Price/Earnings (avg. for comparison categories)

9.72

12.55

17.73

12.41

PEG Ratio (avg. for comparison categories)

1.02

1.62

1.12

1.46

Source: Table and data from Yahoo Finance

Analysts on a consensus basis have a 5-year average growth rate forecast of 9.54% (based on the above table).

Earnings History

12-Mar

12-Jun

12-Sep

12-Dec

EPS Est

0.73

0.81

0.87

0.89

EPS Actual

0.75

0.82

0.88

0.92

Difference

0.02

0.01

0.01

0.03

Surprise %

2.70%

1.20%

1.10%

3.40%

Source: Table and data from Yahoo Finance

The average surprise percentage is 2.1% above analyst forecasted earnings over the past four quarters (based on the above table).

Forecast and History

Year

Basic EPS

P/E Multiple

2003

$ 1.83

12.58

2004

$ 2.07

12.12

2005

$ 2.27

11.55

2006

$ 2.50

12.25

2007

$ 2.41

11.16

2008

$ 0.70

39.07

2009

$ 1.76

14.58

2010

$ 2.23

13.3

2011

$ 2.85

9.42

2012

$ 3.37

10.14

Source: Table created by Alex Cho, data from shareholder annual report, and price history is from Yahoo Finance.

The EPS figure shows that throughout the 2003-2007 period, the company was able to grow earnings. Throughout 2007-2009 earnings contracted. The contraction in earnings was due to the great recession, but following the recession, the company was able to grow earnings.

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Source: Table created by Alex Cho, data from shareholder annual report

By observing the chart, we can conclude that the business is cyclical and is affected by macroeconomics. Therefore the largest risk factor to Wells Fargo is the slowing of international gross domestic product growth. So as long as the United States economy continues to grow, the company will generate reasonable returns over a 5-year time span based on the forecast below.

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Source: Forecast and table by Alex Cho

By 2018, I anticipate the company to generate $5.60 in earnings per share. This is because of cost management, growth in core businesses, and improving economic outlook.

The forecast is proprietary, and below is a non-linear chart indicating the price of the stock over the next 5-years.

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Source: Forecast and chart by Alex Cho

Below is a price chart incorporating the past 10 years and the next 6 years. Detailing 16 years in pricing based on my forecast and price history on December 31st of each year.

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Source: Forecast and chart created by Alex Cho, data from shareholder annual report, and price history is from Yahoo Finance.

Investment Strategy

WFC currently trades at $35.10. I have a price forecast of $49.10 for December 31st 2013. Generally, undervalued stock will experience sudden rallies in order to fetch a reasonable premium relative to historic valuation, or book value. I factored that into my price forecast, making it an important component behind the sudden jump in stock valuation despite the gradual improvement in anticipated earnings.

Short Term

Over the next twenty-four months, the stock is likely to appreciate from $35.10 to $49.10 per share. This implies 40% upside from current levels. The stock is in an uptrend, which further supports my investment thesis.

Investors should buy Wells Fargo at $35.10 and sell at $49.10 in order to pocket short-term gains of 40% through 2013 and 2014.

Long Term

The company is a decent investment for the long term. I anticipate WFC to deliver upon the price and earnings forecast despite the risk factors (competition, regulation, economic environment). WFC's primary upside catalyst is improving economics, growth in financial products, and managing costs. I anticipate the company to deliver upon my forecasted price target of $76.14 by 2018. This implies a return of 117% by 2018. This is a phenomenal return for a financial company.

A higher yielding investment opportunity albeit having higher risk is to buy the Jan 17, 2015 calls at the $37.00 strike. The call premiums trade at $3.00. The price forecast for the end of 2014 is $52.50. The rate of return if the calls expire at $52.50 is 416%, the option will break-even when the stock trades at $40.00.

The call premiums are cheap because investors who are short WFC calls do not anticipate the stock to break out into new all-time highs, and that regulatory risk will keep the premium on growth muted. I don't anticipate this to happen, and the risk-to-reward ratio on the option strategy remains high. The high returns comes with moderate risk (5-year beta of 1.4)

Wells Fargo has a market capitalization of $184.8 billion; the added liquidity makes this an investment opportunity appropriate for larger institutions that require added liquidity.

Conclusion

Investors should remain optimistic on Wells Fargo because of growth, and return to historic valuations. I am strongly convinced that the stock will outperform the Standard & Poor's 500 going into 2013, making it an appealing investment opportunity for those who are willing to take the risk.

The conclusion remains simple: buy Wells Fargo.

Source: Wells Fargo Will Add Substantially To The Fortunes Of Shareholders