Recently analysts at Sandler O'Neill downgraded Wells Fargo (NYSE:WFC) from "buy" to "hold." Within this note they highlighted general economic concerns, lower upcoming earnings estimates and the idea that shares were "already trading at a deserved premium."
Incidentally this downgrade comes just a few weeks after another analyst indicated that shares were now a "sell" due to a price target of $45 against a then price around $49. I previously illustrated why selling because you thought shares might be worth 10% less may not be in the best interest of a long-term shareholder. The reasoning ranged from the possibility of inaccurate estimates and dangerous comparisons, to frictional expenses and the idea that it could actually be good news for shareholders to see lower intermediate-term prices.
Within this article I'd like to highlight a slightly different approach: the idea that even if you were to see a lower multiple formulate in the future, this isn't exactly a worst case scenario. For the short-term speculator it might be, but for the long-term owner a slightly higher starting valuation likely isn't a reason to avoid a security altogether.
Let's start with some history. Here's a look at the business and investment performance of Wells Fargo from the end of 2005 through 2015:
The numbers are a bit skewed by the financial crisis, but there are still some important takeaways. Asset growth was quite impressive, but this was subdued by a lower return on those assets and the share count dilution that took the number of common shares outstanding from 3.5 billion in 2005 up to 5 billion last year. Put together, investors would have seen earnings-per-share growth of over 6% per year.
That's the first thing that stands out to me. Here you had the worst financial crisis in memory right in the middle of your measuring period and yet Wells Fargo still was able to grow earnings-per-share by 6% annually.
Next you have the share price growth, which came in at about 5.6% per annum. Once again we have an interesting takeaway: investors would have seen P/E compression during this time, and yet the share price growth was still reasonable.
Finally, we can add in the dividend component. Despite the massive dividend cut, investors still would have experienced 4% annual payout growth over the decade long period. In total an investor would have seen annual returns on the magnitude of 7.4% per annum. As a point of reference that's the sort of thing that would turn a $10,000 starting investment into $20,000 ten years later.
Perhaps I'm in the minority here, but that's an impressive "look back" in my opinion. Imagine if I would have come to you in 2005 and said: "We're going to have the worst financial crisis you've ever seen in a few years. Wells Fargo will have to cut its dividend dramatically, the share price will drop dramatically, the company's returns are going down, the share count will balloon by 1.7 billion and the ending valuation multiple will be lower to boot."
I'd suspect that many investors wouldn't come close to considering that investment. And yet for the long-term shareholder that weathered the storm, they would have doubled their capital in the last decade.
This is classic reason why it can pay to have a long-term mindset, and not just with this example but in many cases. There are always going to be reasons for concern. Yet ultimately a collection of profitable businesses continues to provide a good deal of value.
With that in mind, let's think about a hypothetical situation for the company's future:
The middle column provides the exact same history that was detailed above as a means for comparison. The right-hand column creates a hypothetical baseline over the next 10 years. And it's important to remember that this is merely a baseline - it ought to be adjusted for your personal expectations.
To be frank some of the suppositions could be misguided, but I believe the takeaway is more or less on par. For instance, you could suggest that the return-on-assets won't increase in the future or that the share count could decrease. I don't disagree; we're making guesses here. Yet the ending estimate of EPS growth of 6% as a baseline works, especially in comparison to other suggestions.
The next part is what a good deal of analysts and short-term thinkers might get anxious about: "what happens if shares go from 12 times earnings down to 11?" And indeed, some even indicate that you now ought to sell shares should you have this particular belief. If this happened tomorrow, then sure that would represent a reasonably lower share price. Yet if happens over the course of holding for years it's not a huge area of concern. It's not the difference between positive and negative. Instead, it's the difference between the share price growing by 6% or say 5%.
Furthermore, a lower intermediate-term price could be a good thing for a number of reasons. If you're going to be buying shares with "fresh" capital or reinvested dividends, you would prefer to do so at a lower rather than higher price. Moreover, if the company is retiring shares, the same logic applies. So a lower price in the future could actually fuel a bit of growth in the way of fewer shares outstanding.
The final part is the dividend, was which still presumed to grow in line with earnings - indicating a payout ratio that remains in the 30's. In total, given the assumptions above, you might anticipate annual gains of over 7% during this period.
This is why it can be helpful to think about the long-term effects of certain situations. It's easy for someone to come out and say "Wells Fargo may not trade at a higher multiple," but less attention is given to what this might mean for the long-term shareholder. In the above example, I presumed that the earnings multiple declined and the payout ratio did not increase. And yet investors could still see reasonable results. Should shares trade at say 13 times earnings or if the company paid out perhaps 45% of its profits, you'd start to see rather solid results rather quickly.
In short, if shares of Wells Fargo are trading at 11 times earnings and you think - and I highlight "think" because naturally the future is unknown - that this ought to be closer to 10 times, this is no reason to fret. For the short-term speculator, this sort of thing wouldn't be good news. Yet for the long-term owner it still implies solid gains and could even be a good thing if it were to happen.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.