Stronger Balance Sheets
Over the past 5 years large banks (JPMorgan Chase (NYSE:JPM), Bank of America Corp. (BAC), Citigroup Inc. (C), Wells Fargo & Co. (WFC)) have slowly rid their balance sheets of the bad debt they accumulated in the 2000s. This made the average share of non-performing loans drop from 5.2% in 2010 to 1.6% at the end of 2015 (source).
This let them set aside less money for bad loans, which is an expense on the income statement. A lower "Provision for Loan Losses" increases total Net Income. However, this is just an estimate of future losses. If they are higher than expected, future expenses will be higher as well.
Data by YCharts
For the past 5 years, revenue has been down for every major bank but Wells Fargo. However, Net Income is up for all of them:
Data by YCharts
This can only be explained by a reduction in costs. Operating expenses for these banks in 2015 is the same as 2010, with the exception of Bank of America. In 2011 B of A had huge writedowns related to bad debt (source), so coming down from those highs is not a great accomplishment.
Basically most of the increase in Net Income for the past 5 years can be attributed to setting aside less money for bad loans.
Source: Own. Data from Morningstar.com
An Uncertain Future
The U.S. economy is doing much better than it was 5 years ago. Unemployment is down to 5% and housing prices are back up. This is good news if you loan money to retail or business customers. However, real median household income has not surpassed its previous high set in 1999 (source).
More loan defaults are a possibility, but only if there are job losses. The lack of substantial raises for the majority of U.S. workers means they can sustain their current standard of living but not improve it. Most people (and banks) learned their lesson and have been deleveraging.
Despite this, a future downturn could increase future Loan Loss Provisions, thus decreasing Net Income for large banks. This is mostly because these provisions are at record lows. And even if nothing increases non-performing loans, these provisions can't go down to zero. Net Income growth based on expense reduction is unsustainable.
Wells Fargo: a diamond in the rough
All banks have improved since the recession, some more so than others. Many people follow Bank of America and Citigroup religiously after they made a killing buying in 2009. Both of these have improved markedly since then.
But I agree with Warren Buffett when he says, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." Even though many banks are undervalued, a good bank can be an even better deal. Wells Fargo is that kind of bank and Warren thinks so too.
WFC has not only improved its balance sheet, it is also earning more money with those assets. Even 5 years ago its Return on Assets was higher than everyone else's.
Data by YCharts
Interest rates moving higher will improve Net Interest Margin, thus further increasing bank ROA across the board. So this higher ROA is all the more impressive since it was earned when rates were at all time lows.
Beating Tier 1 Capital Goals
Additionally, Wells Fargo beats its Common Equity Tier 1 Capital goals by more than its competitors. What are the Common Equity Tier 1 Capital goals you ask? This article explains it in detail, but basically the Federal Reserve and other organizations require each important bank to have a minimum amount of equity on their balance sheet. This prevents them from becoming over leveraged like they were during the recent recession.
Each bank's goal is different based on the riskiness of its assets. Banks now report their Common Equity Tier 1 (CET1) as a percentage of "risk weighted assets" on their quarterly financial statements. Here I have compiled a graph based showing how each bank compared to their goal over the past 10 quarters:
Source: Own. Data from Forbes and 2015 Q4 Financial Statements for each company
You can see that Wells Fargo consistently beat their goal and Citigroup is improving, while B of A and JPMorgan are just barely meeting the requirements. In fact, JPMorgan only reached their goal in the last quarter!
I assign a discount rate of 8% when valuing WFC. They are a stable, tested company in a mostly stable environment. If anything, their earnings have been artificially decreased by lower than average interest rates.
The other banks have higher discount rates because of their lower CET1 and lower growth rates because of lower Return on Assets. Not surprisingly I find WFC to be the most undervalued. Citigroup is the second best and also undervalued.
Source: Own. Calculations by Gurufocus.com
All large banks are in better shape than they were in 2010. But one is in the best shape. That bank is Wells Fargo.
Over time, this will translate to higher Net Income and dividends, and potentially stock price. It may take time for this value to be recognized, so I give it a time horizon of 3 to 6 years to be fully realized. This is Warren Buffett's favorite bank. Get it while it's still on sale!
Disclosure: I am/we are long BRK.B.
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.