Triple Threat Investing: Wells Fargo

| About: Wells Fargo (WFC)

I'd like to preface this article by explicitly indicating that the following commentary is not meant to be a Wells Fargo (NYSE:WFC) purchase recommendation. Everyone is different with regard to their investing style, scope and requirements. With that being said, I'm about to make a reasonably bullish WFC case. Simply note that I'm working towards an investment rationale and not necessarily the selection of an individual security. Incidentally, my recently published book "You Don't Have A Money Problem" - which can be found here - uses a similar tactic.

The "triple threat" is commonly referenced in basketball as a position in which the offensive player has the ability to pass, dribble or shoot from the same starting point. It is an advantageous position as the offensive player has many favorable outcomes in their arsenal. Within the context of investing, especially income growth investing, I'd suggest that the business world has its own "triple threat" position. Let's take a look at Wells Fargo to see what I mean.

Pass = Low Payout Ratio, Reasonable Yield

The pass probably isn't the most exciting option, but it will assist you in achieving your end goal. At the time of this writing WFC was trading at $38.20 a share. We'll call it $38 to keep things simple. In addition, Wells is paying a $0.30 quarterly dividend or $1.20 annually. Over the last twelve months the San Francisco bank earned $3.53 a share. Taken together this roughly equates to a 3.2% current yield and a 34% payout ratio. Not bad. The "threat" or more aptly the positive that one can draw from a reasonable yield with a low payout ratio is the fact that it is relatively easy to increase the dividend without affecting the business model. Let's use the tool to observe Wells' historical payout ratio:

Treating the financial crisis as an "abnormal event," we see that the payout ratio for WFC ranged from 33% to 48% in the decade of "normal" years running up to 2008; for an average payout ratio of just over 40%. Now assuredly it is possible that another financial collapse will occur. In fact it is important to remain prudent in these observations. But I don't think it's necessarily unrealistic to make "normal" examinations. This is especially true if you were to extend the "triple threat" investment rationale beyond the financial sector. In addition to the 40%+ payout ratio history, management has also made it clear that they expect to pay out between 50% and 65% of earnings in the form of dividends and share repurchases. For the purpose of comparison, we'll settle on an intermediate payout ratio of 45%. Now I have no idea if this will happen in a year or a decade, but to continue let's imagine that Wells is able to reach this new payout ratio target in 5 years time. Finally, to isolate the dividend effect and likely understate returns, we'll assume that earnings per share do not grow at all.

What does all of this mean? Well, if WFC is still making $3.53 in 5 years, but now has a payout ratio of 45% this equates to a $1.59 annual dividend. More specifically, this means that the dividend would grow by 5.8% a year for a yield on cost of 4.2%. Granted if you're a total return investor you likely won't be too pleased with the nominal 3.5% annual gain. However, for someone only concerned with a growing stream of income over time, the near 6% dividend growth with a starting yield north of 3% and a payout ratio remaining below 50% doesn't seem all that bad to me.

Dribble = Earnings Growth

I think dribble is appropriate here. Companies tend to make more money over time and "dribbling" would be the equivalent to moving forward. So for this positive investing "threat" we'll assume that earnings per share grow, but the payout ratio remains constant. MSN money quotes analysts coming to a consensus 5-year earnings growth rate of 8.3%. uses a more conservative 6.5%. We'll say that WFC is only able to grow EPS by 6% a year for the next half decade. With share repurchases factored in I certainly don't think that's unrealistic. In 5 years that $3.53 EPS number will translate to $4.72 in yearly earnings. Keeping the same 34% payout ratio the dividend payout is $1.60. We'll leave the current price-to-earnings ratio untouched at just under 11 as well. So this means that the shares would be valued around $51 and you would have collected $7.17 in dividend payments. In sum this equates to an 8.9% annually compounded return. Not too shabby for a below average payout ratio and P/E that never breaks 11.

Shoot = Low Historical Price-to-Earnings Ratio

Viewing WFC through the lens of F.A.S.T. graphs reveals:

Here we see a normal P/E of 15.5 against the current P/E of 10.6. I think shooting makes the most sense with regard to P/E expansion. In basketball if you're well guarded then shooting is naturally the biggest risk / reward move. Within investments there's likely a reason that the P/E is where it is. In turn, formulating investing decisions based on earnings growth or an increasing payout ratio is likely easier to defend than indicating that the market will immediately behave rationally. At the very least the underlying company certainly has control over the first two outcomes, but rarely has much sway in the latter. For arguments sake we'll say that people are willing to pay 14 times what Wells Fargo earns in 5 years. We'll stay conservative and also indicate that EPS and the payout ratio are the same in half a decade as they are today. Fourteen times $3.53 = $49.42 for an annual price return of 5.4% and a total return with a constant $1.2 yearly dividend of 7.8%. Again, this appears to be a reasonable return given that earnings stagnated and the payout ratio remained historically low.

If we look at the "triple threat" outcomes individually I think the correct response is "interesting but not incredible." A payout ratio of 45% equates to a 3.5% annual gain. An earnings per share growth rate of 6% equals an 8.9% annual return. Finally, a P/E of 14 indicates a 7.8% yearly compound increase. But what happens if we were to combine the three? In basketball I'm sure a whistle would be blown rather quickly, so we'll toss the analogy aside. Annual earnings growth of 6% equals a year 5 EPS number of $4.72. Given a 45% payout ratio this means that the dividend grew to $2.12 - a 12% annual rate. Finally a P/E of 14 would indicate a price of $66. All told this comes together to reach a 14.5% average yearly gain. In other words, if WFC is able to grow earnings per share by 6% a year, continue to payout less than half of its profits and people are willing to pay less than 15 times earning then you could nominally double your investment in half a decade. Now I'm not sure if you caught my Target (NYSE:TGT) article or not, but nominally doubling an investment in 5 years time without doing anything that spectacular is something that might catch my eye.

Obviously there were a variety of simplifying assumptions in this example. But that's the underlying point. I didn't have to talk about Wells Fargo to develop the investment rationale. I could have just as easily picked US Bancorp (NYSE:USB) or JP Morgan (NYSE:JPM). For that matter I could have revisited my previous article theses with Walgreen (WAG) or Target. If you can find companies in the "triple threat" investment position - specifically a low payout ratio, reasonable current yield, ability to grow earnings and low historical price-to-earnings ratio - then it's sensible to assume that those type of securities are worthy of further research. It's rare to find all three within wonderful companies, but it's rewarding to know that you only need one or two to be successful. Here's to being in the correct position when your investments are.

Disclosure: I am long WFC, TGT, WAG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.