Think back to mid-1999. I was an analyst at Tiger Management at the time and, like most of my colleagues there, was utterly confounded by the valuations technology stocks had achieved. The Nasdaq composite had risen 22% in the first half alone. Most of us at Tiger thought tech group was wildly overpriced: the best of the bunch, Microsoft (NASDAQ:MSFT), was trading at 36.5 times forward-year earnings.
But the stocks just kept on going up. Julian Robertson stayed short a basket of names he thought were the most screamingly overvalued until the pain of even-higher prices forced him to cover. From mid-1999 until the end of the year, the Nasdaq (which had already risen by 22% since January 1, don’t forget) rose an additional 51%. By the end of 1999, Microsoft was trading at 62 times 2000 estimated earnings.
That turned out to be the peak for Microsoft, but the Nasdaq proceeded to rise another 26% from the beginning of 2000 until March 10 when, as we now know, the bubble finally burst. Microsoft subsequently fell by 66%, the Nasdaq overall cratered by 78%.
If you were as negative about technology valuations as I was in mid-1999, you had ample opportunity to look foolish. Do you remember what the bulls were saying? It was the dawn of a new era. The old metrics didn’t count anymore. The new economy would replace the dynamics of the old economy entirely. Profits were beside the point.
Remember? In any event, we all looked even dumber when March, 2000 rolled around, as the Nasdaq kept zooming.
Then—pop!—the bubble finally burst and everyone started acted rationally again--and those of us who’d been skeptical all along turned out to be right, if not exactly rich.
You likely see where this is headed. I believe the valuations of financial stocks today are every bit as crazy, albeit as a mirror-image, as tech stock valuations were at the end of 1999. But with a proviso. The financials today face one big uncertainty that technology stocks at the dawn of the decade did not: the risk of irrational regulation.
If (and right now it’s a not-insubstantial if) bank regulators don’t panic and plug in extreme, irrational assumptions into this new “stress test” they’re concocting for the large banks, I believe the stocks of the best-run, best-positioned banks will rise by three to four times over the next two years and the second tier of large banks will rise by five to ten times.
Look, for instance, at the institution that’s likely the best-managed and best-positioned of the large banks, Wells Fargo (NYSE:WFC), to see what might happen. As I write this, the stock is trading at around $9 per share, down over 70% from its high in September.
If you buy Wells Fargo today at $9, here’s what you get:
Great growth. Take a look at Wells’ acquisition-adjusted growth figures (from 6/31/07 to 12/31/08) on the table below, and compare them to those of its big-bank peers (JP Morgan Chase (NYSE:JPM), Citigroup (NYSE:C), and Bank of America (NYSE:BAC)) and a broader list of nine peers (those first three big banks plus BB&T (NYSE:BBT), Capital One (NYSE:COF), Fifth Third (NASDAQ:FITB), Regions (NYSE:RF), Suntrust (NYSE:STI), and US Bancorp (NYSE:USB)):
In addition, in the most recent quarter, Wells’ loan portfolio grew by 2.4% sequentially while average loan growth at the three large banks fell by 2.1% over the same period, and fell by 1.1% at the top-nine peers.
Most importantly, Wells Fargo has shown superior growth in its pre-tax, pre-loan-loss-provision earnings, compared to sharp declines at its peers.
An Incredible Franchise. Wells Fargo has the best franchise of the largest banks, in my view. The company is broadly diversified geographically, and has strong presence in some of the country’s fastest-growing markets. Plus, it has broad product diversification, and a strong core deposit franchise. On that last point in particular, take a look at Wells’ average cost of deposits compared to its peers.
The Average Cost of Deposits (in Percent)
Wells Fargo 0.91
Large-Bank Peers 1.59
Top 9 Peer 1.73
The Industry’s Best Management Team. The country’s big banks are run by some extremely talented management teams. (With some exceptions, of course.) But if I had to pick one as best-in-class, it would be Wells Fargo’s. Chairman Dick Kovacevich and CEO John Stumpf are well-known and (rightly) respected by investors. In addition, the company’s four senior vice-presidents, Howard Atkins, Dave Hoyt, Mark Oman, and Carrie Tolstedt, are among the best at their positions in the industry.
A Proven Track Record of Success. When Dick Kovacevich arrived at Wells predecessor Norwest in 1986, he immediately helped lead the company out of a credit hole it had dug for itself, then proceeded to turn the company into one of the great banking institutions in the country. It is a multi-decade, multi-cycle record of success that says a lot about what Wells is capable of in the future. No wonder Berkshire Hathaway (NYSE:BRK.A) is the company’s largest investor.
Conservative Accounting. A hallmark of Wells / Norwest under Kovacevich (and his predecessor, Lloyd Johnson) has been a commitment to extremely conservative accounting. This was on display most recently with the approach the company took to accounting for its acquisition of Wachovia, as well as its reserve build for its own loan portfolio in the fourth quarter. Look, for example, at how Wells split Wachovia’s $118 billion Pick-a-Pay residential mortgage portfolio. The company deemed some $60 billion of those loans to be “credit impaired”, and wrote them down by a whopping 41% at the time of the acquisition. The other $58 billion, deemed not credit impaired, lately has a 30-day delinquency rate of just 0.1%. Even so, the company established meaningful on-balance-sheet reserves for those loans.
So great growth, great management, an outstanding, multi-cycle track record, and conservative accounting. Yet Wells’ stock trades at just five times next year’s consensus earnings estimate, and just 2.5 times our estimate of the company’s normalized earning power. Given such a low valuation, it’s not hard to see how the stock could quadruple in just the next two years, once the credit freeze finally thaws.
The biggest risk isn’t credit (as we’ve seen, any potential problems have marked down aggressively, and are heavily reserved for), but rather government regulation. It’s possible, for example, that the Treasury’s new “stress test” could be so extreme that it puts Wells’ capital ratio below the Treasury’s new standards. If that happens, the Treasury has said it would inject additional capital via convertible preferred. I highly doubt regulators will view Wells as undercapitalized, but even if the company does have to take a slug of new capital, the upside in the stock price would be limited to two to three times, not four to five times.
Just as there were lots of tech companies with bad business models that were doomed to fail following the bursting of the tech bubble, a lot of banks are doomed to fail now as the credit crisis plays itself out. But the whole industry isn’t going out of business, that’s for sure—even though lately the market lately seems to be pricing it that way. I believe regulatory risk is being wildly overstated. Meanwhile, once the storm passes, companies like Wells Fargo will emerge as stronger and more effective competitors than ever.