Wells Fargo: Analyzing Warren Buffett's Biggest Bet

| About: Wells Fargo (WFC)

Summary

Wells Fargo is Warren Buffett's largest equity holding, and he bought more shares last quarter.

Generally speaking, bank stocks are safer than they have been in years and can provide dividend portfolios with exposure to stocks that benefit from rising interest rates (unlike utilities/REITs).

Wells Fargo offers a dividend yield of 3% and trades for less than 12x forward earnings. Is it a buy for dividend growth investors?

Wells Fargo (NYSE:WFC) is Warren Buffett's largest holding, and he first bought into the company in 1989. Buffett owns businesses with lengthy operating histories, durable competitive advantages, and excellent management teams, and Wells Fargo is no exception.

Warren Buffett even added to his stake in the company during the fourth quarter of 2015, making the stock an even more timely idea. While we don't own many financial companies in our Top 20 Dividend Stocks portfolio, Wells Fargo is one we are fond of.

Despite the negative stigma attached to banks following the financial crisis, these companies are generally in great financial shape and appear relatively undervalued compared to the market. With a dividend yield greater than 3% and mid-to-upper-single digit dividend growth potential, Wells Fargo is worth a closer look.

Business Overview

Wells Fargo was founded in 1852 and was the third-largest bank in the country as measured by assets at the end of 2015. Wells Fargo's 90 different business lines collectively generated over $86 billion in revenue last year from a diversified mix of banking, insurance, investment, mortgage, and consumer and commercial finance services.

Unlike many big banks, Wells Fargo has little exposure to investment banking and trading operations. Instead, the business focuses on simple lending businesses (e.g. mortgages, auto loans, commercial financing) and fee income.

Wells Fargo's revenue is split nearly equally between traditional loan-making (53% of revenue), which generates net interest income from a 50/50 mix of commercial and consumer loans, and noninterest income (47% of revenue) from brokerage advisory services, commissions, mortgage originations, card fees, deposit service charges, and more.

The company serves more than 70 million customers through its network of more than 8,600 store locations and 13,000 ATMs, as well as its website and mobile banking application.

Business Analysis

Banks primarily gather deposits and loan them out for interest income, as borrowers, consumers and businesses are most concerned with getting access to dependable financing at the lowest interest rate possible.

In other words, banks are largely commodity businesses, and the lowest cost operator usually survives the longest in commodity markets. As one of the biggest banks in the country, Wells Fargo has numerous cost advantages, which begin with its track record of gathering low-cost deposits from consumers and businesses that it can lend out at higher interest rates.

According to Wells Fargo's annual reports, the company's total deposits have grown from $3.7 billion in 1966 to $1.2 trillion in 2015, representing growth of 12.6% per year over that period. As seen below, Wells Fargo's deposits have grown at a healthy high-single digit rate in recent years as well. The company has more retail deposits than any other bank in the country and is ranked third overall in total deposits.

Wells Fargo Dividend

Source: Wells Fargo Investor Presentation

Importantly, Wells Fargo funds most of the loans it issues with its deposits. The company was paying just 0.08% on its deposits as of the fourth quarter of 2015, and its total funding cost including all sources was only 0.25% in 2015.

Thanks to its cheap funding base, Wells Fargo is virtually guaranteed to generate a positive return on its loan portfolio despite today's low interest rate environment.

In some ways, banks are similar to another type of Buffett's favorite financial companies - insurance companies. Insurers write new policies to receive money from premium payments, and banks take in money from deposits.

Both types of cash will eventually be paid back in the form of insurance policy payouts or a customer withdrawing funds from the bank. However, the insurer or bank can earn a return with the money before it needs to be given back. Insurance companies invest in stocks and bonds, and banks make loans.

As long as these investments are conservatively managed, insurance companies and banks can make a lot of money from their cheap "borrowed" funds.

Wells Fargo serves one in three households in the U.S., and its convenience and brand recognition are two reasons why it has enjoyed such strong deposit growth. The company maintains industry-leading distribution channels, including storefronts, ATMs, online, and mobile. This allows Wells Fargo to serve customers in more locations than any other bank.

Many businesses that loan money from banks must also maintain a large deposit with their bank if they desire to secure a line of credit, adding to Wells Fargo's low-cost deposit base. Once a consumer or business opens an account with a bank, switching costs are also created given the hassles involved with closing and transferring accounts, especially when most mega banks are perceived as being somewhat comparable to one another.

Thanks to Wells Fargo's scale, efficient operations, and low-cost funding, the company maintains a relatively low efficiency ratio. The efficiency ratio essentially measures the percentage of a company's revenue that is consumed by operating costs; lower numbers are better.

The company's scale and efficient operations helped it realize a 58.1% efficiency ratio in 2015, which is nearly 10 points better than the average efficiency ratio across all community banks and lower than all but one of its mega-bank peers.

Wells Fargo Dividend

Source: Wells Fargo Investor Presentation

As a result of its cost advantages, Wells Fargo's return on assets and return on equity metrics are also roughly 30% higher than the average community bank. The company's asset turnover, as seen below, is also the highest of all mega banks.

Wells Fargo Dividend

Source: Wells Fargo Investor Presentation

Wells Fargo is also a durable business because its loan book is conservatively managed and its revenue sources are well diversified. The company recorded a very low level (0.33%) of net charge-offs as a percentage of total loans in 2015, and its Common Equity Tier 1 ratio of 10.7% is well above the regulatory minimum required for well-capitalized institutions.

Buffett's ownership of the stock is another vote of confidence in how management runs the business. In his 1990 shareholder letter, Warren Buffett wrote the following about investing in banks:

"The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity…Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a "cheap" price. Instead, our only interest is in buying into well-managed banks at fair prices."

Wells Fargo's management team clearly checks his boxes to make the company his largest equity stake. As we mentioned earlier, it's also comforting to know that Wells Fargo maintains a nice revenue balance between interest income and non-interest income. This helps the overall business perform better across various economic cycles.

Overall, we believe Wells Fargo has a large moat. The company gains competitive advantages from its substantial scale, low-cost deposit base, strong capitalization, leading market share positions, and conservative management team. We expect Wells Fargo to be around for a long time to come.

Wells Fargo's Key Risks

Bank stocks are more challenging to analyze than most other types of businesses because it's hard to understand what is really going on with their balance sheets and financial health, which are the result of numerous subjective accounting assumptions made by management.

In other words, things usually look fine… until they don't.

When you think about how a bank makes money, it takes in deposits and lends them out at higher interest rates. To earn an attractive return on equity, banks take on financial leverage to magnify their profit margins.

As long as people and businesses feel safe putting their money with the bank and the bank's customers continue making their interest and principal repayments on their loans, the bank mints money.

However, banks' leverage cuts both ways. When delinquencies rise and loans can no longer be paid, a bank's equity can quickly be wiped out.

To use a simple example, suppose a bank makes a $100 loan to a manufacturing business. To fund the loan, the bank uses $96 of deposits on hand and contributes $4 of its own capital. If the manufacturer is unable to repay its entire loan and only pays $97, the bank's capital will be hit first instead of depositors' money. In this case, the bank would see 75% ($3) of its capital wiped out.

If things get really bad, a poorly managed bank that took too much risk can be completely wiped out. This is a simple explanation of what happened during the housing crisis when consumers could not make their mortgage payments and banks had taken on far too much financial leverage and credit risk.

Wells Fargo has proven to be a conservative lender and benefits from having many sources of non-interest income, so we don't worry so much about this risk. However, some investors are concerned about the impact that nonperforming oil & gas loans could have on banks. Fortunately, these loans account for only 2% of Wells Fargo's total loan portfolio, and the company has already marked down the value of many of them.

In addition to energy sector weakness, banks are impacted by economic growth and interest rates. Simply put, loan growth is stronger when consumers and businesses are healthier, and net interest margins generally expand as interest rates rise. In today's sluggish environment, interest margins and loan growth remain suppressed.

Finally, the biggest "risk" to banks is regulation that has actually made them less fundamentally risky. However, greater safety has come at the expense of lower returns on equity and higher compliance costs.

In response to the financial crisis, regulators implemented a number of major changes to the financial system. The Dodd-Frank Act is the most significant financial reform legislation since the 1930s and was enacted in July 2010.

These rules implemented new, more conservative requirements for big banks like Wells Fargo in regards to how much leverage and liquidity risk they can take and the mix of assets they can hold in order to promote financial stability.

As a result of these new capital requirements, many big banks have shrunk their operations, substantially reduced their leverage, and incurred higher costs to comply with new regulations to boost safety.

To provide an example, the chart below shows the percentage of "zero risk" assets on bank balance sheets over the last 10 years. The proportion has about doubled for global systematically important banks (GSIBs).

Click to enlarge

Source: Oliver Wyman

Some investors worry that banks have essentially become utility stocks due to the increased regulations to make them safer. With less financial leverage, a more conservative mix of assets, and more capital required to absorb greater losses without becoming distressed, banks will never return to the high returns they earned prior to the financial crisis.

While we acknowledge this "new normal," we believe Wells Fargo is well positioned to earn some of the highest returns in the sector and appreciate the lower risks of banks in general.

Dividend Analysis: Wells Fargo

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Dividend Safety Score

Our Safety Score answers the question, "Is the current dividend payment safe?" We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Dividend investors won't forget Wells Fargo's decision to cut its dividend by 85% in 2009 to save $5 billion per year, protect against further loan losses, and fund its 2008 acquisition of troubled Wachovia.

Despite the dividend cut, Wells Fargo was actually one of the best positioned banks going into the financial crisis. The Federal Reserve declared that Wells Fargo exceeded the capital levels required for well-capitalized banks in 2009, and its balance sheet remained healthy enough to let it acquire Wachovia at a bargain price.

The Federal Reserve has since required banks to maintain much more conservative balance sheets. If you don't believe us about banks' improved financial health, perhaps an excerpt from a 2013 interview of Warren Buffett will help:

"The banks will not get this country in trouble, I guarantee it. The capital ratios are huge, the excesses on the asset side have been largely cleared out. Our banking system is in the best shape in recent memory."

Wells Fargo has a strong Dividend Safety Score of 86. Barring another financial crisis, which seems extremely unlikely, we think the company is well positioned to continue paying and growing its dividend.

Wells Fargo's dividend has consumed 36% of its reported earnings over the past 12 months. As seen below, the company's payout ratio has historically been between 30% and 50%. However, the company's financial leverage caused earnings to plunge during the financial crisis, which sent its payout ratio to 160% and forced a dividend cut.

Wells Fargo Dividend

Source: Simply Safe Dividends

We can also see that the company's reported earnings have been stable outside of the financial crisis, highlighting Wells Fargo's large and diversified revenue base. Stable earnings make a dividend payment more reliable.

Wells Fargo Dividend

Source: Simply Safe Dividends

Not surprisingly, Wells Fargo also generates a consistent return on equity. However, as we mentioned earlier, we can see the business earns a meaningfully lower return on equity compared to the years leading up the financial crisis. Banks are much safer and better capitalized today due to increased regulations.

Wells Fargo Dividend

Source: Simply Safe Dividends

Turning to the balance sheet, the company maintains an "A" credit rating from Standard & Poor's and appears to be financially healthy. Overall, we believe Wells Fargo's dividend is very reliable. Banks are healthier than they have ever been, and Wells Fargo is particularly conservative in the way it runs its business.

Dividend Growth Score

Our Growth Score answers the question, "How fast is the dividend likely to grow?" It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Analyzing the growth potential of a bank company's dividend is tricky compared to other types of businesses. Large bank holding companies such as Wells Fargo are required to submit annual capital plans to the Federal Reserve in order to gain regulatory approval for dividend payments and share repurchases.

Wells Fargo must comply with strict leverage ratio requirements and liquidity coverage rules to avoid restrictions on capital distributions. Capital distributions can also be restricted upon the occurrence of various risk management triggers, such as stress tests.

Fortunately, Wells Fargo is extremely well capitalized. The company has grown its dividend every year since 2010 and last received permission from the Federal Reserve in March 2015 to increase its quarterly dividend by 7%.

As seen below, Wells Fargo's dividend is now higher than it was prior to the housing crisis (4.0% annual growth rate since 2005) after sharply recovering over the past five years.

Wells Fargo Dividend

Source: Simply Safe Dividends

Should interest rates begin to edge up over the coming years, we believe Wells Fargo can generate a mid-single digit earnings growth rate. When coupled with the company's 36% earnings payout ratio and healthy capital levels, we think its dividend can continue growing at a mid-single digit pace. However, capital distribution will remain subject to the Fed's blessing.

Valuation

WFC's stock trades at 11.8x forward earnings estimates and has a dividend yield of 3.0%, which is significantly higher than its five-year average dividend yield of 2.4%.

Investors have beaten down shares of bank stocks in recent months on speculation that interest rates and economic growth will remain lower for longer, limiting loan growth and net interest income.

While stricter capital requirements prevent banks from earning the high returns they enjoyed prior to the financial crisis, we believe they can still generate a return better than utility stocks (Wells Fargo's return on equity last year was about 14%) while enjoying at least mid-single digit earnings growth as the recovery continues.

Under those assumptions, Wells Fargo's stock appears to offer annual total return potential of 7-9%, and it currently trades at a meaningful price-to-earnings multiple discount to utility stocks and the broader market.

Conclusion

Wells Fargo is a wonderful company with numerous competitive advantages, including its scale, brand reputation, growing low-cost deposit base, diversified mix of businesses, broad distribution network, efficient operations, and conservative management team.

While bank stocks will always be more challenging to evaluate given the number of subjective assessments management teams must make to account for loan quality on the books, most banks are much healthier and better capitalized today than ever before.

It will take time for Wells Fargo to regain its reputation as a blue chip dividend stock, but we agree with Warren Buffett's recent buying activity that suggests he thinks the company is attractively valued and remains a great long-term investment.

The stock will also benefit if interest rates begin to rise, providing diversification to dividend portfolios that are otherwise overly dependent on low-interest rate beneficiaries such as utilities and real estate investment trusts. Our Conservative Retirees dividend portfolio holds several of these types of stocks, so a company such as Wells Fargo can help balance its exposure to interest rate risk.

Disclosure: I am/we are long WFC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.