Description

Wells Fargo represents an opportunity to take advantage of a company that will likely be able to profit from its position as one of the “last big banks standing.” In fact, some evidence indicates that this is already taking place, as WFC continues to make high-quality home loans while at the same time taking advantage of low-interest loans from the government to do so.

At the same time, I believe the market has seriously overpriced the future volatility of WFC, providing the investor with a mechanism for unlevered returns in the range of 30 percent.

To take advantage of this opportunity, an investor can either buy WFC shares at the market and sell an at-the-money call option out to Jan 2010, or equivalently simply sell a put option out to Jan 2010, provided that the investor sets aside the money to purchase the stock should that put be exercised. I will analyze the covered-call case, as it is simpler.

At current prices, a share of WFC will cost $29.48 (though it moved lower in the after-hours, possibly offering a better deal at the start of the new year – it may move still lower because of the expected close of the Wachovia deal). Selling a call struck at $30 out to Jan 2010 nets the investor about $7.00. Assuming WFC continues to pay its dividend throughout 2009 (a reasonably safe assumption in my view), the investor will also receive $1.36 in dividends, bringing the total cash-in to $8.36 across 2009.

Assuming that WFC ends 2009 at or above $30 per share, the investor will then take home $8.36 for every $22.48 invested (because the $7 is received immediately, I do not consider it as part of the return computation). This represents an annual return of 31 percent, far above what I would consider a standard “goal” return on a value investment.

Obviously, the key consideration in this investment is the risk associated with a significant depreciation in WFC across 2009, so I will devote the remainder of this writeup to that question.

1. Berkshire has invested heavily in WFC. As of September 30, Berkshire owned 290,407,668 shares of WFC, for a total investment of about $8.6B. Buffett has stated publicly that he is adding to the position, and his average purchase price is above $30 per share. While I am not going to argue that Berkshire and Buffett are infallible, there is significant evidence historically that following him is an excellent strategy for outsized returns. Also, I view him as someone uniquely able to assess the creditworthiness of a bank in this environment.

2. I believe the tax shield associated with the Wachovia acquisition provides WFC with significantly more value that the risk they are taking on with the troubled assets included in the merger. WFC has estimated it can write down $74B in losses from Wachovia’s loan portfolio, meaning that assuming WFC manages to continue in business for the foreseeable future it should be able to shelter around $26B in taxes from the government, assuming a 35 percent tax rate.

3. I realize that credit ratings have come under fire of late, but WFC continues to command a Aaa rating from Moody’s and AA+ from S&P.

4. While Wells has been hurt alongside all the banks by the mortgage mess, they largely avoided the worst of the MBS-related investments. Additionally, they were able to raise $12.6B earlier this year to increase the strength of their balance sheet.

5. The biggest risk across the next for WFC, and probably all banks, is the recasting of option-ARM mortgages, which they’re getting largely from the Wachovia deal. Unlike many other banks, WFC has already accounted for losses associated with these loans in their projections – they will mark 2/3 of them to market immediately upon the close of the deal and the remainder over the next three years. Total expected losses are around $43B, including about 30 percent of the option-ARM total. I think this is a reasonable, and probably conservative, estimate given what I’ve seen from other banks.

6. Perhaps most importantly, it is pretty clear at this point that the government and/or the Fed intend to keep rates low for the foreseeable future. This, combined with the government’s determination to keep the financial system solvent, makes it fairly unlikely that a strong survivor like WFC will face hardship over the next year.

From a valuation perspective, should WFC’s stock be trading below $30 at the end of 2009, the investor who purchased the covered call investment here would be holding stock with a cash cost of $21.12 per share (assuming you incorporate both the option premium and the dividend into the purchase price). At that point, assuming no change in the dividend rate, the investor will be receiving annual dividends of 6.4 percent.

And, without putting too much emphasis on book-value in an environment where the value of assets is deeply uncertain, the investor will hold WFC at a market cap of $70.2B versus a book value of about $47B as of the end of September 2008. Or, from a projected earnings perspective, using conservative earnings projections of around $2.25 per share, the investment has a P/E of around 9.4.

I believe the most likely case is that WFC’s stock is near or above the current levels, meaning that the investor will walk away with the dividend and the option premium, representing more than a 30 percent annual return. Worst case scenario is that the investor winds up owning the stock at a $21.12 price, which is around 60 percent of what Berkshire paid for its holdings.

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