If the performance of top regional and global U.S. banks is compared over the period of the 2008 recession, it is evident that in terms of stock price, Wells Fargo (NYSE:WFC) and JP Morgan (NYSE:JPM) are the two banks which suffered the least with a stock price decline of 18% and 20% each. In this period, other large banks faced a severe downhill trend. The stability put forth by Wells Fargo and JP Morgan was able to outperform the S&P 500 index over the two year recession period as the index posted a decline of approximately 40%. Four years after the financial meltdown, the banking stocks started to show a strong upward surge again. In the first quarter of FY13, these companies posted strong earnings, which resulted in further improvements in the stock price. It appears that the premiums offered by banking stocks are becoming attractive enough to rid investors of their reluctance. In this analysis, I aim to evaluate Wells Fargo as a prospective investment as it is amongst the safer opportunities in this high-risk industry.
Stock Performance and Revenue Profile
Lower risk is generally associated with lower volatility. This is not the case with Wells Fargo as the bank's stock price has shown a substantial improvement over the last year.
The above chart shows the stock performance of Wells Fargo as compared to two other regional banks, PNC Financial Corp. and US Bancorp over a period of one year. The chart clearly shows that Wells Fargo has outperformed its regional peers by posting a stock price appreciation of 31.48% as compared to the price appreciation of less than 20%.
Source: Barclays Capital Presentation, May 2013
The above charts represent the company's revenue profile. The outstanding degree of diversification pursued as a business strategy by Wells Fargo is very attractive for risk-averse investors. Half of the company's revenues come from interest income whereas the other half comes from fee generation. The fee generation section is also extremely diversified and this variety of exposures at different levels of operations forms an exemplary business model for regional banks. The major proportion of fee generation comes from Investments, Mortgage Banking and Deposit Services.
Interest Margin Trends and Financial Health
Interest margins have been amongst the major concerns faced by banks in the U.S. as the expansive monetary policy has induced a low interest rate environment. The decrease in interest rates has adversely affected the net interest margins of banks.
Data Source: Value Walk
The above chart shows the trend of net interest margins experienced by Wells Fargo since the beginning of FY11. The chart clearly shows how the net interest margin of the bank has reduced from more than 4% to 3.48% in the first quarter of FY13. In my opinion, this declining trend will not continue for long. It will begin to stagnate in FY14 as the notion of tapering is already being considered by the Federal Reserve. In another two years, the interest rates might start improving as well.
Source: Value Walk
The above chart shows the net interest margins obtained in the first quarter of FY13 by the major players in the banking industry. Wells Fargo has the highest net interest margin against these large players despite the strong decrease in margins experienced by the bank.
Source: Source: Barclays Capital Presentation, May 2013
The above chart shows the Tier 1 common equity ratio of Wells Fargo over the last five quarters. The ratio has improved from 9.98% to 10.39% on a YoY basis. This shows that there has been a reduction in the financial risk associated with the company and the proportion of the highest class of equity has improved in the bank's capital structure.
In terms of valuation, most of the well performing large banks are undervalued on the basis of valuation multiples as compared with the overall industry. This represents the investors' reluctance towards the banking industry but the recent surge in the prices of banking stocks suggests an improvement in the situation.
Data Source: Morningstar
The above table shows key valuation metrics for Wells Fargo and its competing regional banks along with the overall industry average. The table shows that the bank is undervalued across most valuation indicators. The substantial undervaluation coupled with the stronger dividend yield provides substantial upside potential for investors.
The exemplary business model and the marked advantage over competitors in difficult economic circumstances make Wells Fargo a strong financial entity. The most important factor in support of the bank is its low-risk approach. At the same time, the undervaluation of the bank across various valuation multiples, coupled with the recent retreat in overall market, provides investors with a lucrative entry point. Keeping these factors in consideration, I propose a buy stance for Wells Fargo as the bank has a strong potential for price appreciation in the coming years.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.