(Originally part of a client letter; please excuse any statements that may be obvious to this community.)
We’ve been eyeing Wells Fargo for a while. It used to be one of the best-run banks in the US.
As everyone on VIC is aware Warren Buffett is (was?) one of its largest shareholders. Charlie Munger loaded up on WFC during the GFC through DJCO.
Even though BRK has reduced their exposure, we still believe WFC offers an attractive, low-risk return profile.
WFC has a very large and stable deposit base, which gives the company a cost advantage over its competitors when it comes to funding its loans. Despite buying a very troubled Wachovia, which bought very troubled Golden West, Wells Fargo performed solidly through the GFC.
We don’t know when the trouble started, but WFC’s focus created an incentive for employees to sell products to customers at any cost. Employees then opened a few million checking and savings accounts for customers who never asked for them.
The actual harm to individual customers was tiny (we are talking $20 or so per consumer), but the cost to the bank was enormous – its reputation suffered, it paid billions in penalties, regulators put the company under a giant microscope which resulted in a much higher cost structure (more on this soon), and the Fed basically restricted the company from growing its loan book until all the problems are solved (the restrictions are still in place, though they were eased slightly in April).
So there are a lot of things not to like about WFC, but the price of WFC stock reflects this. JP Morgan trades at around 1.2 times bvps, while WFC was trades at 0.65 times book. The stock is down more than 50% year to date.
Aside from its obvious cheapness, we see the following in WFC: It is the largest bank on the West Coast. It is incredibly inconvenient to switch banks, so despite the headlines, customers are sticking around. We don’t want to minimize any kind of malfeasance, but if my bank had opened me an extra account, I probably wouldn’t have noticed it. As long as I was getting good service from the bank and could get whatever financial products I needed, I’d do nothing. This is what most WFC customers did – nothing.
WFC needs a culture reboot, and they have the right guy for that – Charles Scharf. Scharf worked for Jamie Dimon at JP Morgan, where he was CEO of retail and financial services; then in 2012 he went to run Visa. He is highly respected in the industry. What made Wells Fargo great is still there – its enormous footprint and huge customer base. WFC used to have a good culture and Scharf does not face an impossible task in bringing it back.
The light went on for us when we listened to Scharf in WFC’s latest earnings call. The following especially caught our attention:
I have acknowledged in the past that our expenses are too high and that we're building road maps to improve our efficiency ratio. To repeat, there is nothing structurally different about Wells Fargo that should prevent us from being as efficient as our large peers, but we are far from it. For us to bring our level of efficiency close to our peers, the math would tell you we need to eliminate over $10 billion of expenses….
This will be a multiyear effort for sure, but we would like to see a reduction in expenses next year....
It is important to note that I deeply believe that this exercise is about making us a better and more efficient company, not just about reducing expenses. We have too many management layers, spans of controls for managers are too narrow, and we have resources dedicated to activities that are not a priority today. This cannot continue. [Emphasis ours.]
The pandemic gave Scharf a license to cut out $10 billion of expenses. That may not sound like a lot when the US government just created $6 trillion out of thin air, but the market capitalization of Wells Fargo is $100 billion. If Scharf keeps his promise – and we don’t see any reasons why he cannot (WFC’s expenses are significantly above its peers) – then if you put a 10 times multiple on earnings that would come from these expenses going away, you’ll get the rest of the company (which is, by the way, very profitable) for free. In other words, we are paying $25 for a company that can earn $6–8 per share.
Now let’s talk about the risk. In addition to the risks of WFC’s failing to fix its culture (a more difficult task and thus higher-risk) and cut costs (lower-risk), there are two additional risks: higher losses due to the pandemic and a drastic decline in interest rates, which would in turn reduce WFC’s net income margin (the difference between what it charges on loans and its cost of borrowing). We stress-tested different scenarios.
Wells Fargo has had good underwriting discipline. The people that sign off on loans are not the same people that are incentivized to originate them. What gives us some comfort in this area is that for two years regulators have limited how much WFC can grow, and so it had to turn away business and thus had much stricter underwriting than it did in the problem period.
In our stress tests we challenged the level of losses WFC has to endure before it starts losing money. During the GFC WFC loan losses as a percentage of total assets were 2% (a good chunk of these losses were generated by Wachovia). This time losses have to be 2.4% before WFC’s net income goes negative. Also, losses would actually spread out over more than one year, and thus WFC should have plenty of resilience to handle the pain of credit losses.
Another piece of good news for WFC: Since the GFC US regulators have gone medieval on the US banks – they’ve been run as utilities, and their balance sheets are the best they’ve ever been. Unlike in 2008, the US financial system can take some serious beatings by the pandemic and still come out okay.
Another risk of a more permanent nature is lower net income margins. Svenska Handelsbanken, which we also own, operates in the land of negative interest rates and earns a 1.5% net income margin. (It borrows at negative rates and lends at exceptionally low rates.) Today WFC’s net income margin stands at 2.7%. We took it down to 1.5%, and we still get $2.80 of earnings per share or so (assuming the bank cuts costs). In this scenario, at 8 times earnings we get $22.40, 11% below today’s price of around $25. The downside from NIM compression is relatively limited.
WFC requires us to dwell not on what the company is today but on what it can become (or come back to): one of the best banks in the US. Most importantly, its success is not path-dependent – its balance sheet and still very strong franchise can get WFC through thick or thin.
We put this trade on through options – $15 strike-price WFC calls when the stock was ~$25. So the intrinsic value of our option was $10 ($25 - $15). The extrinsic value was $1.29, or a 12% cost over a year and half. Our total cost was thus $11.29.
So in other words, if in a year and a half (expiration January 21, 2022), Wells Fargo stock is trading at the same price of $25, the intrinsic value will not have changed; it will still be $10. But time value and volatility value would converge to $0, and thus the option would be worth $10. We’d be down 12% on this 1% position.
However the leverage of this option is about 2X. So in other words, in committing 1% of the portfolio to Wells Fargo we created a 2% position. This 1% will behave as a 2% position on the upside and downside, too. In other words, for the most part this 1% in-the-money call option in WFC will behave as if we invested 2% in WFC stock.
Overall, we believe WFC and in the money WFC options offer investors asymmetric risk-reward from here.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.