I'm never that comfortable setting out to refute part of an article that I have disagreed with on Seeking Alpha. Sure, it's all part of the constructive debate we enjoy here, but it can feel like unfair sniping and worse risks missing the overall thrust of a piece by jumping on a particular aspects of it. But this one was too interesting to ignore, so with that health warning in place, here goes. The article in question is this interesting discussion of Wells Fargo (NYSE:WFC) from Activist Stocks.
Here's my own take on what to my eyes was the main point of the article.
This is the key sentence:
WFC trades at a hefty premium to other big banks and still has some of the overhang of the fraud charges. Instead, it's best to find opportunities elsewhere - such as with Citi (NYSE:C) - which is cheap and better positioned in faster growing areas like Latin America and Asia.
The value premium is given at 1.6x book value for Wells with the nearest large bank being JPMorgan (NYSE:JPM) and the author notes that this is twice the P/BV of Citigroup.
Before discussing this, I should say I'm a buyer of Citi (and for that matter Bank of America (NYSE:BAC) among the big banks). But I'm also a buyer of Wells Fargo, and I think the best comparator is U.S. Bancorp (NYSE:USB). I also think it's important for investors to at least be aware of the framework I use to get to this view. Let's walk through all of this and see where we end up. To start, I would look at the valuation differently.
In itself, the multiple of book value on which a bank stock finds itself doesn't tell us anything about its value relative to its peers. To make sense of the price to book, you need to know the ROE which as you know is given by net income/average equity for the period. And if we are dealing with price/equity (P/BV) in relation to earnings/equity (ROE), then we are really looking at a PE ratio!
To decide if Wells Fargo's valuation is vulnerable opposite its peers, we need to look at how its PE lines up. A high ROE bank will trade at a higher multiple of book than a low ROE bank, other things equal. But they might both trade on the same PE. In other words the P/BV and ROE relationship is just a derivative of what the market wants to pay for the stock's EPS.
On this basis, Wells Fargo isn't at all expensive in relation to JPMorgan, but is certainly trading higher than Citi and that's why I prefer Citi to JPM. In the table below, the different EPS growth rates in 2018 reflect sensitivity to rate assumptions and share buyback schedules. To my mind, WFC is only a tad more expensive than JPM two years out. As I said, there's no question about Citi's relative attractiveness.
Activist Stocks made the point that Citi's Asian and Latam exposures are a long term positive in that they will provide higher growth than the U.S. market and I made a similar point recently myself.
Shorter term, remember these geographies are a potential drag for Citi due to the risk that Trump will cause a stronger dollar for a prolonged period and might trigger economic distress in China and other Asian EM through his trade policies. But as I said I'm a buyer of Citi. I just wouldn't sell WFC to buy it though.
What I want to do here is introduce another bank into the discussion. U.S. Bancorp
My main contention here is that comparing WFC to JPM and Citi is a bit misleading. Sure, they're all very big banks. But the closest comparator for WFC is in fact U.S. Bancorp.
Compare the following two charts. USB and WFC have similar income structures that feature a lot of non interest income for deposit driven retail-corporate banks. By the way, both WFC and USB have a notably weak quarter of non interest income over the timeframe presented and both of these are on-offs. Note that WFC's weak 4Q non-interest income for 2016 does not equate to a collapsing franchise after its recent account scandal.
Here are the two banks' net interest margins and total revenue/assets ratios: these are very difficult to separate.
You can run a lot of these ratios and you will see similarly striking similarities. Cost/assets 4Q 2016? 2.7% for both. Average pre-tax profit/assets last eight quarters? USB, 1.89% WFC 1.8%. That's high. Most banks would reckon on 1.4-1.5% pre tax as a great result.
Now with this in mind, let's go back to valuation:
So if we compare WFC to a leading domestic peer that is in many ways a very similar bank, with a high quality income structure and equivalently strong pre-tax profitability, then we find that WFC is attractively valued. Banks like these two are rare with rich income mixes that are very stable and give a powerful cushion at times of asset quality deterioration - simply because there is more income to absorb credit losses. In addition you won't see the capital markets volatility you will from time to time in JPM and Citi. That's why they are often more expensive in terms of PE vs. international banks with large trading operations, but not in fact that much more expensive than JPM. Certainly, WFC doesn't stand out vs. U.S. Bancorp. and USB is not expensive vs. regional bank peers.
I would not disagree with Activist Stocks about the risk of further malpractice coming to light at WFC, however, this may well not happen and the company will get on the right side of its conduct issues eventually. Bottom line: don't sell WFC. Own it alongside USB, Citi and BAC.
Disclosure: I am/we are long WFC, CITI, BAC, USB.
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.