Financial Stock Valuations: The Mirror Image of Tech Stocks in '99?

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 (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 (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 (JPM), Citigroup (C), and Bank of America (BAC)) and a broader list of nine peers (those first three big banks plus BB&T (BBT), Capital One (COF), Fifth Third (FITB), Regions (RF), Suntrust (STI), and US Bancorp (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 (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.

Disclosure: None

Comments

[Mr Black:]

Good analysis, there a lot of very bullish reasons to like WFC. However I think you may be glossing over the consequences of their huge commercial loan/real estate portfolio getting sick. That could be the next egg to break for the banks.

Feb 22 11:03 AM

[Top Gun:]

Wells is the only bank, one of the few stocks, that I own.

Congress will appropriately heavily regulate the banks. They have proven to be crooks. Instead of letting them fail, regs will be instituted to insure that capital remains at high levels and risks are manageable.

Economy is food production, transportation, building when actually needed, etc, etc. Banks merely facilitate by transferring money from one place to another. Any leverage is simply inflationary in the sense that it bolsters prices in the short term, just like helping out mortgage borrowers by the federal government.

We may eventually realize that leverage is the dumbest thing a mature society can allow. I don't know, but banks only benefit from as much leverage as they can generate. Tacit backstop by the federal government must be removed in order to reduce risk taking. Wells is the only major bank that I can see who never assumed they would get help from the government, and leant accordingly. And gee, they actually make money!

Feb 22 11:10 AM

[Jim Hawthorne:]

Thanks for the analysis, Tom! I don't quite see the analogy to tech a la 2000, but that's okay...
In a nutshell, your valuation considered primarily growth, management, a good track record, and in your view, conservative accounting. In conclusion, you rate WFC as a great buy.
I would feel more comfortable with your recommendation if you went into more detail on the rather gloomy picture of WFC's debt; granted, their total debt is very hard to accurately establish. Even by what some would call 'conservative accounting', WFC's debt to bond holders and others stands at around $250Billion, and seen in this light, a PE around 5.9 certainly is understandable and justified. (BTW, there really was a time when PE's above 10 were considered a sign of high OVER-valuation, but that was before our time!)
The really ugly question is not what share price WFC might go to in the next few years. It's the question of what additional hurdles might WFC have to surmount in the more immediate future, a Commercial Real Estate meltdown being the most immediate.
The most troublesome thing about your recommendation to me concerns your own disclosure. If WFC is so great a buy, why aren't you holding it?

Feb 22 11:17 AM

[User 282957:]

Yes,why aren't you hoding WFC if you think WFC is such a good buy?

On Feb 22 11:17 AM Jim Hawthorne wrote:

> Thanks for the analysis, Tom! I don't quite see the analogy to tech
> a la 2000, but that's okay...
> In a nutshell, your valuation considered primarily growth, management,
> a good track record, and in your view, conservative accounting. In
> conclusion, you rate WFC as a great buy.
> I would feel more comfortable with your recommendation if you went
> into more detail on the rather gloomy picture of WFC's debt; granted,
> their total debt is very hard to accurately establish. Even by what
> some would call 'conservative accounting', WFC's debt to bond holders
> and others stands at around $250Billion, and seen in this light,
> a PE around 5.9 certainly is understandable and justified. (BTW,
> there really was a time when PE's above 10 were considered a sign
> of high OVER-valuation, but that was before our time!)
> The really ugly question is not what share price WFC might go to
> in the next few years. It's the question of what additional hurdles
> might WFC have to surmount in the more immediate future, a Commercial
> Real Estate meltdown being the most immediate.
> The most troublesome thing about your recommendation to me concerns
> your own disclosure. If WFC is so great a buy, why aren't you holding
> it?

Feb 22 11:44 AM

[David Roskoph:]

You are absolutely correct in your psychological analysis of the markets. All the market needs to do is crete a story that's credible, regardless of reality. Back then we were in the first inning of a new era and now the plating field is about to be razed. It alludes to a public, unfortunately too easy to manipulate.

Feb 22 11:50 AM

[Mad Hedge F...:]

Wells Fargo Bank (WFC) has been in a free fall for the last two weeks, as investors bail out of the stock in fear of nationalization, or an Alt-A loan loss driven bankruptcy. The stock has vaporized 47% in three weeks, down to a new 12 year low. Veloceraptor like hedge funds have been major short sellers of the stock because it is one of the last banks with any meat still on the bone. Demand for out of the money puts is soaring. The stock is being dragged down further by big selling of bank and financial ETF’s, like the Financial Select Sector SPDR (XLF), which has WFC as its second largest holding at 8.74%.

Feb 22 12:00 PM

[ROLEXDAYTONA:]

i am not an expert on technology, but i am looking to buy TYH, X3 long technology stocks.
let's live and see, the earnings of techs look encouraging, lower than that it can not be.

Feb 22 12:07 PM

[RSAAKKS:]

Your rationale for holding WFC will most likely prove correct, although timing for realizing any meaningful returns is year's away. It will depend on: 1. How soon the mortgage business and housing market begins to stabilize 2. General economy has to show signs of REAL recovery, meaning employment starting to increase and corpoarte profits beginning to rise. Until we see such recovery, loan protfolios of banks will remain a drag causing more write offs and losses. Finally, interest rates have to remain at reasonable levels, 10 yr treasuries below 5%. If all these happen, WFC will go up 4-5 fold. If even one of the three conditions remain negative, bank stocks will go no where, and market will have tough time crawling out of this hole.

Feb 22 01:05 PM

[weargue:]

As one commenter pointed out, it's down to a 12 year low. that's not exactly the worst ever, bottomless pit, world coming to an end price. so 2009 versus 1999 is that we have cnbc, btv, seekingalpha, zillions of financial websites, the babyboomers getting old and finally wising up to finance...that's what's changed.

one financial conference on CSPAN this week had an economist point out that at the 1933 low, per person production was down 40 PERCENT. know what it is now after all this gloom and doom? 0.2 PERCENT. yes, not a misprint zero point 2 percent.

Feb 22 01:08 PM

[Compare GM ...:]

And these facts helped me lose how much last week in WFC?

C gained back 13% in extended hours Friday, while WFC did what?

This isn't a market for rational thinking. I have no idea what this market is doing. Fundamentals have absolutely nothing to do with anything anymore. If anyone out there knows, please... fill us in. But don't even think the best run companies are benefiting above the rest. AFL comes to mind also, as it continues to rape my portfolio. They've even shot the duck. I'm completely boggled.

Feb 22 01:31 PM

[ArtfulDodger:]

Mr. Tom Brown:

You are right about irrational markets: they can stay irrational longer than one's bankroll can last.

But that's not what I fear with WFC; it's the company's $32 per share of debt.

With that type of debt load, one mistake and they're right in there with Citi.

Any comments in that respect?

Feb 22 01:47 PM

[BerkeleyBob:]

I understand that WFC's loan portfolio includes a large amount of HELOCS, and given the continuing decline in housing values, I am not comfortable putting my money into a well-managed bank. it is very difficult to evaluate risk and return; I agree that some serious moolah may be made by contrarian investing, but too much of what I have at present remains under water...

Feb 22 02:20 PM

[pulcheralius:]

Good analogy Tom, but in 2000 we didn't have the wild card called Uncle Sam. The unpredictable behavior of the government which at times is completely motivated by political and not economic reasons has built a risk premium in financial stocks that may be justifiable. There is an increasingly large political block that wants to natonalize BAC and C. If they succeed, don't you think a lot of WFC customers will flock to the "safe" gvt owned banks? Look at what happened in Europe just a few months back - billions of deposits flowed into countries will blanked deposit guarantees and out of countries will more limited guarantee structures.

Feb 22 04:00 PM

[MattZN:]

There has been a pretty serious disconnect between stock prices and fundamentals since the crash. People may not recall but after WaMu and Wachovia went down the government stepped in by bumping up FDIC levels and providing numerous guarantees. The bears temporarily turned away from the banks and to the Energy sector and started promulgating all sorts of mythical problems, such as companies not being able to get financing, oil dropping to $15, and so on and so forth. Combined with the forced selling that was occurring at the time, they managed to push stock prices down on oil-exposed companies to unheard-of levels thinking they could force the companies into bankruptcy or low-priced mergers.

Except it didn't work. It took several months but the companies themselves proved the bears wrong by being able to easily fund their cap-ex spending. It didn't happen for one reason: The bears forgot that these companies all had seriously good cash flows. Now the sentiment in the energy infrastructure space is that the companies are not in any danger of going under, and exposure to commodities prices is virtually the only driving factor on their prices.

Right now we are seeing the same thing happen to the Banks. The bears are screaming their heads off that banks will have to raise more cash, that reserves are draining away, that customers will make another run on deposits (never mind who would they run to if they did!), that all potential portfolio losses (never mind that impossibility of modeling it) all have to be recognized instantly and OH BY THE WAY that means they are all insolvent and should be 'nationalized', even though nationalization would mean the government would have to immediately recognize a few trillion in losses. Never mind that the big banks are still able to pay their bills and still able to add to their loan loss reserves. Exaggerate a little here, exaggerate a little there, and before you know it you have a full scale panic!

And yet, while the Banking sector has its own severe problems, distinct from the Energy sector, the savings-grace is still the same for companies like Wells Fargo. Wells is generating cash flow, lots of it, and it seems to be going up rather then down. Lots of banks will be going down in this environment. Wells will not be one of them.

I don't want to downgrade the difficulties the banking sector faces. They are very severe. Wells stands to lose billions. On the other-hand, Wells is generating revenue at a nearly 80 billion dollar run rate on the lowest cost of money in years. Much of the arsenal the bears had to take down WaMu and Wachovia has been effectively stoppered by the government. There is not going to be a run on Wells deposits, or BofA's for that matter (if BofA goes down it will be from their derivatives portfolio, not from their banking operations). The question is not what Wells' total losses would be if they were realized today, but what their losses would be if they were realized over a few years, because the rate DOES matter. It matters because Wells has serious cash flow.

The differentiator for the banking sector is going to be cash flow and margins. Who has enough, and who doesn't have enough. Wells has enough.

For a long, any price for Wells common below $20 is more or less just betting that the bank survives. For Wells a recovery to $20 will be fairly quick once people realize that they aren't going to get bankrupted. As much as I kicked myself for not waiting longer (my basis on the common is above $15), my response is still to buy down here and not sell.

As a measure of how crazy this market is, Wells pfds dropped to near $11 on Friday before bouncing back to $13+. I stopped buying the common and started buying the preferreds down there. I wonder if I'll ever see Wells pfds drop even lower? I'm saving some cash in case they do, so I can buy more.

And, as a measure of just how crazy this market is, some of BofA's preferreds dropped to $4 on Friday. I don't like BofA due to the opaqueness of its derivatives portfolio, but that didn't stop me from spending a little cash on such an easy bet. I think even BofA has a good chance of surviving at least a few years. BofA's preferreds are literally a free call option that pays you to wait and has no expiration date.

So here I am. My Wells common is seriously underwater, my Wells pfds are in pretty good shape, my little speculative BofA pfds are seriously in the black. And yet, I'm happy? I am. Sure, I kick myself for not being able to bring the basis down more (I'll have more chances to reduce the basis if volatility spikes it up again), but generally speaking I think Wells is the best bet on the survival of the U.S. financial system.

As a long I will be watching Wells common and Wells pfds carefully to see if any other opportunities come up to transfer more of the common position into the pfds. I do think there is some risk to the common dividend. It won't break my investment thesis if it gets cut. A second round of TARP funding would, though, unless it is simply in the form of a revolving credit line offered by the government so Wells wouldn't have to pay 1.2 billion a year in interest on the TARP money.

-Matt

Feb 22 04:12 PM

[Fitz919:]

Wells Fargo is in deep dodo, just like all the other big banks. The only way they survive the continued fallout from Variable Rate Mortgage Scams, is if the Regulators continue to look the other way, and ignore systemic insolvency.

Feb 22 04:48 PM

[Amouna:]

Tom. WFC's primary business market is California, which is a state in a dire financial condition due to homeowners foreclosures and slumping economic activity that has put the entire state on verge of collapse. How would that empact the the future of WFC?

Feb 22 06:05 PM

[Moon Kil Woong:]

It would be better to see comparisons between banks than a focus on one bank if you wish to compare it to the tech stock run up in the past. Also, techs had a growth story, a paradigm shift, and bright future. I don't hear these arguments about banks.

Feb 22 11:49 PM

[Stone Fox C...:]

constructe,
Tom made plenty of compaisons to the other banks. WFC was much stronger on all the ones he pointed out.

Tom is a great bank analyst and he is most likely correct about WFC. The real question is whether now is the time to buy. Might still be way too early.

Feb 23 11:19 AM

[User 305589:]

Tom, thanks for another great article with a lot of meat and not just some assumptions, opinions and biases - as it has become so common on SA.
imho, WFC is a truly digital stock now. If the govt and the fed can handle the situation with enough patience and without doing an overkill but also without letting the economy go into freefall, then wfc is a steal here.
If not, then it's anybody's guess what the common and likely also the pfd will be worth a year or two from now.
However, one thing can be said for sure, imo: common and pfds will either trade at double or triple the current price or they will be much much lower. There is no inbetween. A $11 tag makes zero sense for wfc over the longer term.
I like the pfds better though, as they put me ahead of the common in the structure and pay a very juicy dividend. my favourite are the pfd-L at this point and a few otm bull call spreads expiring in Jan 11 look interesting, too

Feb 24 03:10 AM

[Charlie Bottle:]

Tom,

There is one word that is missing from your article: Leverage.

It's really very simple.

If you are leveraged 20 to 1 and asset prices decrease 10% you are bust.

The 60 year credit expansion cycle which was kept artificially high by greenspan&co has come to an end. When credit contracts asset prices fall.

That's why most banks are going bust.

Feb 25 12:21 PM