Observing the developments in the banking sector over the past several years has been extremely interesting, and serves as an excellent case study of market psychology. The T.A.R.P. program and private capital raises strengthened balance sheets that had been cut to shreds by unscrupulous lending practices. "Toxic" debt was provisioned for and charged-off accordingly, while the stocks of most of the large banks traded at huge discounts to tangible book value.
As credit metrics have continuously improved, costs have been cut and positive momentum in the housing market has strengthened loan demand. Profits have been increasing consistently and the combination of retained earnings and higher capital requirements have the banks on stronger footing than they have been on in decades. Bank shares have seen extreme volatility, particularly in 2011 when the European Crisis created uncertainty, and now finally we have seen the beginnings of what I expect to be a huge 3-5 year recovery in bank stocks.
After a year in which financials outperformed all other sectors, analysts have begun issuing buy ratings after seemingly focusing exclusively on the negatives when the stocks could have been acquired at much cheaper levels. Meredith Whitney and Mike Mayo are just a few of the analysts whom were extremely late to see the obvious opportunity. At times like this it is important to reassess the investment rationale, and Wells Fargo & Co (WFC) is an interesting situation because the stock trades at 1.26 times its $27.64 book value per share, while most of the other large U.S. banks are trading below book value.
This premium is warranted due to Wells Fargo's industry leading 2012 1.46% and 13.35% return on assets and equity, respectively. Several analysts have put a "hold" rating on WFC citing valuation relative to peers. Many TV commentators and market pundits have focused on pressure from net interest margins and a decrease in the mortgage origination pipelines as being causes for concern. My advice to investors is to ignore this type of short-term thinking and focus on the key question, which is whether or not Wells Fargo represents an attractive investment opportunity at the price that is offered.
At $34.77 Wells Fargo has a market capitalization of roughly $183 billion, meaning that the stock is trading at less than 10 times 2012 net income of $18.897 billion. In 2012, news headlines were dominated by concerns over Europe and the Fiscal Cliff, but in this anemic economic environment Wells Fargo grew net income by 19%. Wells Fargo currently boasts greater than 30% of the U.S. mortgage market and has benefitted tremendously from the robust refinancing environment, which has been spurred on by government policies and incredibly low interest-rates.
All of Wells Fargo's businesses have been growing but it is important to keep in mind that while refinancing activity has been extreme, mortgage originations outside of Fannie Mae and Freddie Mac programs has not been too great. In addition, net interest margins are very low, and it is my belief that Wells Fargo's true earnings power has been masked to a great extent because of this. Lastly, the regulatory environment has continued to be a huge obstacle in terms of litigation, while Wells Fargo and the other large banks are carrying a huge amount of excess costs related to legacy mortgage servicing and repurchases.
At less than 10 times earnings, Wells Fargo carries an earnings yield of roughly 10%, which is quite good considering the 10 year treasury yield is about 1.89%. The stock offers a dividend yield of about 2.22%, which has the potential to be increased by 25-50% over the next couple of years as excess capital continues to build. I estimate current earnings power to be slightly in excess of $4, and can compound by 10-15% per annum over the course of an economic cycle. Tier 1 Capital and Total Capital ratios are at extremely robust levels of 11.75 and 14.63, respectively. The company's Tier 1 common equity under Basel III has increased to 8.18%, putting WFC in an excellent position to increase capital returns to shareholders pending the 2013 CCAR process.
Another common theme in disparagement of the banks has been the idea that the companies now resemble utilities, instead of the 15-25% ROE compounding machines of the past. I believe that this paradigm shift to higher and less-risky capital ratios is actually extremely positive for the industry and for shareholders. While higher returns on equity typically warrant higher valuations, the improved capital metrics and lower leverage levels should significantly reduce the potential for large losses, which lead to equity issuances and other problems when the economy hits the skids.
Most market participants seem to have some lasting anxiety or concerns about investing in banks, after the nightmarish Great Recession, which was only surpassed by the Great Depression in terms of financial crises over the last century. I believe investing through the rear-view mirror is a recipe for poor returns and instead I believe the focus should be on the impact of these transformative changes. At some point I believe sentiment will change materially causing these stocks to rally, and only when the valuation reflects the fundamentals or my investment thesis changes would I look to sell.
Often utilities trades at 15-17 times earnings with the dividend yield being a key driver to the valuation. As banks have been retaining earnings and building capital, the dividend payouts and share buybacks should grow at the fastest rate of any industry over the next 3-4 years. Interest rates have nowhere to go but up over the long-term, which will benefit net interest margins. The large banks' business models are purposefully counter-cyclical so it is important not to focus too much on any one area, including net interest margins.
When rates are low there is more opportunity for mortgage originations, refinancings and investment banking activities. When rates are higher, generally the economy is performing better and net interest margins are higher. The additional costs associated with regulatory changes and legacy assets will eventually diminish, bolstering profitability for the large banks. When the economy picks up steam and unemployment gets under 6.5%, I believe returns on equity for Wells Fargo could go to 15-17%. This would warrant a price/book of 1.4-1.7 in my estimation, and that book value should rise considerably over the next several years even with the expected increases in the dividend payout.
On January 11th, Wells Fargo reported extremely robust 4th quarter earnings of $5.1 billion, up 24% YoY. Earnings per share were a record $0.91 and earnings per share have grown for 12 consecutive quarters. Total revenue of $21.9 billion was up 7% from a year ago, while pre-tax pre-provision profit increased 12%. There was some noise in the quarter associated with a settlement on foreclosure litigation, and strong returns on private equity investments. There was also a tax benefit but the business trends are undeniably positive. Period end loans were up $30 billion form the 4th quarter of 2011 and were up $17 billion from the 3rd quarter, despite concerns over the "Fiscal Cliff." Strong deposit growth has been a recurring theme with average deposits up $64 billion from a year ago, and were up $29.6 billion form the 3rd quarter.
While net interest margins were down, interest income has held steady and actually increased in 2012 overall due to the huge deposit growth. When margins improve, Wells Fargo will have a radically higher earnings power level associated with the deposit base than it did prior to the Financial Crisis. It isn't just the interest income but it is also non-interest income associated with more accounts, and higher cross-sell ratios spread across the organization.
When I had less experience investing, I tended to take profits earlier after large gains. Taking profits quickly is a very common in present-day investing dogma in a market environment that has become increasingly transaction oriented, spearheaded by marketing efforts of television and financial professionals. Having worked in finance for many years and in many different organizations, I've witnessed the conflicts of interest associated with many firms, and I believe that investors would benefit from John Wooden's famous quote of "don't mistake activity for achievement." The investment opportunity in banks and financial stocks overall has been and continues to be huge. The combination of earnings and dividend growth, safer capital structures, and investor sentiment that can only improve, will likely lead to explosive returns over the next 3-4 years.
Of course, there will be volatility and some of the other banks such as Citigroup (C), Morgan Stanley (MS) and Bank of America (BAC) might have more growth potential, but I believe that Wells Fargo can be a cornerstone investment over the next 10-15 years due to its best-in-class business model. Banks tend to grow along with the U.S. economy and the best managed banks pick up the greatest proportion of profit and earnings per share growth.
No investor has shown more confidence in Wells Fargo than Warren Buffett and the hallmark of his investment philosophy is his truly long-term investment attitude. When you can buy a business with the ability to compound at 15% per annum, at a price close to book value with a reasonable risk-profile, the opportunity is too attractive to pass up. Declines in the stock price should be looked at buying opportunities, and at T&T Capital Management (TTCM) we are very comfortable selling long-term puts on WFC to generate income, or to manufacture a cheaper entry-price into the stock. Over the truly long-term, Wells Fargo's higher return on equity potential and lower risk-profile should enable superior returns to most of its competitors.