It's usually not too terribly complicated to spot a journalist overreaching when it comes to investment analysis; a fair number display a lack of understanding of nuances of the specific industry. What's more dangerous for uninitiated investors, however, is when an article actually contains a kernel of truth, but presents it in a fashion which clouds its true implications (or lack thereof).
Such is the case with an article published today by a usually reliable source - Bloomberg. Their piece titled "The Accounting Wizardry Behind Banks' Strong Earnings" concludes with the following nifty soundbite:
"Bank earnings are a joke," says Paul Miller, a bank analyst at FBR Capital Markets(FBRC) in Arlington, Va. "They are very poor quality, but investors are just embracing them."
I won't comment on the quality of earnings at "banks" as a whole. Why? Well, because I haven't reviewed the earnings of "banks" as a whole, so I can't make an educated comment on whether or not they are a joke. (This is a purely neutral statement - don't read anything into it, because there's nothing there. I haven't analyzed every bank's earnings in enough depth to make or reject a blanket statement on their earnings quality.) However, I have followed Wells Fargo (WFC), and I can say that as far as I can tell, their earnings were certainly not a joke, and are not purely accounting wizardry.
There are several issues to consider here. First is the reserve releases. It is indeed true that they will not continue forever (an Evercore analyst believes they will soon decrease) and do not represent cash generated by the underlying business during the current period. But it's also important to remember that reserves are a bit of a zero-sum game - the only reason Wells (and other banks) have reserves to release now is that they previously over-reserved, which led to decreased earnings in the past. So for analysts taking a longer-term view of the fundamental earnings power of Wells Fargo (or any other bank), quarterly fluctuations in reserves are just noise.
And on that note, it's important for investors to remember that Wells Fargo's fundamental earnings power is very strong; even if you assume that the 10% boost from reserve releases goes away entirely tomorrow, there are multiple other positives that more than offset this supposed problem. There may be banks out there for which earnings quality is poor. Wells Fargo is not among them.
The first is substantial non-real amortization charges, which I will not discuss in depth because they should, by now, be common knowledge. In Warren Buffett's 2012 letter to Berkshire shareholders (page 12-13), he notes that Wells Fargo's annual earnings were understated by $1.5 billion due to recurring amortization charges that are non-real fictions of GAAP accounting. If you flip to page 183 of the 2012 annual report from Wells, you'll find this handy table (please note that some amortization is a real expense, but the portion related to core deposits is not):
A second tailwind for Wells' earnings: the long-awaited rise in interest rates. While net interest margin was compressed this quarter due to. In response to a question from Marty Mosby of Guggenhim, CFO Tim Sloan noted:
We are very asset sensitive. The disproportionate share of our loan portfolio is floating-rate in an environment where the short-end of the curve starts to increase which, at some point it will. We believe that that will be a net addition to revenues because our loans will probably reprice faster than our deposits. You have seen that before with Wells Fargo in prior cycles.
(Conference call transcript here.)
Wells Fargo is hardly the only asset-sensitive bank, of course, but its low-cost deposit base certainly puts it in a quite favorable position for the eventual rise of interest rates. In my estimation, and that of smart investors I respect (like Chris DeMuth, whose long bond short in 2013 worked out very well), the normalization of interest rates is a when, not if.
The third tailwind is increasing consumer confidence and similar trends in the macro. This is a positive for loan growth: as the CFO noted, "I am hearing more, when I talk with customers, about their interest in building something, adding something, investing in something."
Finally, when evaluating any bank's earnings quality, you have to figure out how repeatable and defensible their earnings are. To do that, you have to look at the breakdown of where those earnings come from, and understand what drivers will affect them moving forward.
The headline news is that mortgage revenue got slaughtered thanks to refi volume pulling a scared turtle as interest rates rose off generational lows. However, as has been made famous by Mike Mayo and Wells management riffing on the horses analogy, the bank's earnings are very strongly diversified, which allows it to do well in multiple interest rate and macroeconomic environments. Wells' Q4 supplement shows this graphically.
To me, this is the mark of quality earnings. There is not an overreliance on a single source, which makes future earnings (and growth) less tied to any one factor.
Beyond that, there's plenty to like about Wells. They've built a very strong base of Tier 1 capital and are well-positioned for Basel III. They have requested regulatory permission to increase capital returns next year, and have substantial financial horsepower to increase both dividend and buyback activity.
In the end, I certainly respect Bloomberg's talented journalists and the great work they do in general; as such, I will lend the article's author the benefit of the doubt. The financials sector is quite broad, and each bank has unique strengths and weaknesses; as I previously mentioned, I am not nearly enough of an expert to make a blanket statement of the quality of all banks' earnings. What I can say, however, is that Wells Fargo is in a very strong position, and is poised to grow earnings in the coming years. With a valuation that's hardly demanding, investors shouldn't let the occasional headline dissuade them from taking a look at the stock. I'll leave you with a quote from Wells CEO John Stumpf on the conference call:
"We sit here this January as an economy, and frankly as a company, in better shape than I have sat here in the last five or six Januaries."
Pretty compelling stuff, right? So don't throw the Wells Fargo baby out with the bathwater.
Disclaimer: This is solely my opinion, not an investment recommendation or solicitation, and may not represent the views of my employer(s), associates, or other related parties. No guarantees made to accuracy or completeness. I am long the companies mentioned in the disclosure and may change my position at any time without notification. Please see the full disclaimer in my profile, and do your own due diligence before making any investment.
Additional disclosure: I am long Wells Fargo TARP warrants.