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Summary

  • The Banking sector has been facing difficult times with earnings growth.
  • Consistent earnings growth performer Wells Fargo still trading at cheap valuation.
  • What investors want to make WFC trade at a higher valuation.

The Great Recession brought many challenges to the U.S. economy and forced the government and the regulators to make changes to bring back growth and to strengthen the rules and regulations. One of those changes was to lower interest rates, which reached historically the lowest levels since 1971. While this was in the right direction to spur economic growth, it paved the way for many more changes in the banking sector.

Let's look at what are the things that prompted banks to go after the initial changes in their sector. Low interest rates significantly decreased the yields that the banks could earn from the loans that they made. At the same time, the slow-growing economy did not provide the growth opportunities that the banks need to offset the negative impact of lower interest rates on earnings. In addition, increased pressure on improving the credit quality has decreased the scale at which the banks lend.

Regulatory efforts to improve the standards of the banking sector added to these problems that the banks have already been facing. Liquidity requirements, especially for larger banks, put a real dent in their bottom-line earnings in the recent past.

While it may not be as much improvement as the banks need, the low interest rates and stringent rules and regulations have increased the credit quality of the banks. This has resulted in little need for the banks to maintain large provisions for loan losses.

As a result of changes, the growth opportunities have been squeezed. This has created a trying time in the banking sector for year-over-year earnings growth. There are not many options available for banks to offset the damage that the previous changes are causing to their earnings.

To keep earnings steady and growing, banks have tried to gain more efficiency through cost cutting. The related savings measures and improvements to asset quality would not have been possible if the banking sector was in a normal state. At the same time, banks have also tried to utilize their resources more effectively.

This situation reminds me of the story that when everything is as you expect, it will be an easy walk for you. However, when there are difficult and uncommon obstacles in front of you, it forces the inexperienced racer in you to the forefront, which can cause a lot of damage if not controlled well.

This difficult growth environment presents the opportunity to recognize Wells Fargo (NYSE:WFC) as the bright star in the banking group. While other large banks took similar actions as described, what differentiates Wells Fargo from them is consistency; its recent quarterly report is the 17th consecutive quarter with earnings growth.

Other banks did many of the same things in cutting costs, making reserve releases and focusing on areas that have more room for growth. But they have tumbled at some point and become greedier at times, which has caused serious problems in their earnings. It requires great alignment to control the racer in you and do the right thing (and not becoming greedier) when actions work well.

(click to enlarge)

WFC data by YCharts

However, even consistent quarterly earnings growth has not impressed investors; that is why Wells Fargo is still trading at a cheap valuation. What investors want to make Wells Fargo trade at a higher valuation is real growth in earnings. Unlike earnings growth driven by cost-cutting measures and reserve releases, or the difficult growth environment that the banking sector has been facing, is the real culprit behind the cheap valuation of Wells Fargo; this makes many investors stay away from the banking sector.

This difficult growth environment definitely creates fear in the investors' mind that the bank's year-over-year earnings growth will not remain strong, and at the same time, investors who seek a more favorable growth environment will stay away from the banking sector.

However, this environment will soon change, as the Fed tapering has already started, and interest rates are expected to rise in the near term. Banks have become thinner in their spending, credit quality has improved tremendously and losses are at historically low levels.

Any changes in the difficult growth environment to a more favorable one (starting with the rise in interest rates) will definitely be a nice upward kick in bank earnings. This is especially true for banks like Wells Fargo, which has been consistent and effective in its efforts to keep earnings growing. WFC should be the first bank to benefit from the upcoming changes.

Source: Wells Fargo: Leaner And Meaner, But More Is Required