Wells Fargo: The Comeback Kid

Potential upside for this boring "boomer" bank stock is anything but dull

Newsletter Update:

In order to establish a more regular schedule, my plan going forward is to write 1 article per week and publish them on Friday mornings. This way I don’t pressure myself to write too often and burn out, but also am motivated to write weekly.

Thank you to my 200+ Substack subscribers, and please feel free to provide any feedback to help improve this newsletter!

---

One of my favorite investing quotes is from hockey player Wayne Gretzky. When interviewed about his success in always making plays on the puck, he famously explained:

I skate to where the puck is going to be, not to where it has been.

Investors must keep this quote in mind as they consider Wells Fargo (WFC), the banking stock that has perennially underperformed and raised more red flags than a Communist parade in the past 5 years.

But forget the past, as the low expectations baked into the current valuation for WFC has set it up for a comeback story that could be studied in many future Harvard Business School cases to come.

---

Background

First, let’s start with a history lesson. Prior to the Great Recession, WFC was regarded as a top-tier bank and traded at a significant premium to its peers. Even Berkshire Hathaway (BRK) owned a large core holding in WFC stock, giving it the Buffet stamp of approval. The company was renowned for its ability to “cross-sell” financial products to existing customers, as well as for its dominant scale which it further increased through its 2008 acquisition of Wachovia.

Fast forward to 2016, and the first hints of the robo-account scandal started breaking on the news. Pressure from management to cross-sell had led WFC employees to create fake customer accounts. Punishment was swiftly levied from the government in the form of an asset cap that limited WFC’ total assets to less than $2 trillion. Former CEO John Stumpf was replaced with new CEO Charlie Scharf in 2019.

---

Investment Thesis

Given the negative press, why do I think WFC is a buying opportunity? There’s 3 main drivers behind my bullish thesis

• Expansion of net interest margin

• Lifting of Fed asset cap

• Opportunity for major cost reductions

1) Expansion of NIM

WFC relies more on net interest margin than most other major banks given that it generates most of its revenue from lending vs. trading/fee-based business (like a Goldman Sachs). Net interest margin (NIM) refers to banks generating margin by lending longer-term at higher rates (e.g. 30 year mortgage, 60 month auto loan) while borrowing short-term at lower rates (often from the Fed).

When 10/30 year rates collapsed in 2020, this drastically shrank NIM’s for all major banks including WFC. But the 10-year has now recovered to 1.6%+, and with an economic recovery and likely inflation on the horizon, I can see the 10-year returning to 2018 levels of 3%+. This would disproportionately benefit a bank like WFC which heavily relies on NIM margin.

2) Lifting of Fed asset cap

The $2T asset cap imposed by the Fed has limited WFC’ ability to grow relative to its competitors. Case in point JP Morgan Chase (JPM) has been able to expand its assets from $2.5T in 2016 to $3.4T at end of 2020, which has fueled strong revenue/operating profit growth. In Feb 2021, it was announced that the Fed has approved WFC’s risk management & governance overhaul, moving it closer to removing this punishment. It does not benefit the US government to handicap one of its major retail banks, so it’s a matter of time before the cap is eventually removed. And the day this is announced, I could see the stock have a big “gap up” day.

3) Major Cost Cuts

A common way to measure a bank’s cost structure is the efficiency ratio, which is a bank’s non-interest expenses divided by revenue. According to this metric, Wells Fargo currently has the highest cost structure of the 4 major US banks (JPM, BAC, Citi, WFC) with an efficiency ratio of 82% in 2020 vs. 58% for best-in-class JPM.

However, I actually see this as a positive since there is a lot of low-hanging fruit to be picked in terms of right-sizing workforce, closing unproductive branches, and automation/digitalization of manual work processes. New CEO Charles Scharf have started major initiatives on these cost-cutting opportunities.

---

Valuation

WFC currently trades at less than 1.4x price to tangible book value (P/TBV). Best-in-class JPM trades at over 2x P/TBV, while middle-of-the-road Bank of America trades at roughly 1.8x.

With major cost cuts, asset cap removal, and continued turnaround under Scharf, there’s no reason why WFC should continue to trade at a significant discount to peers. If WFC can achieve a 1.6x P/TBV (midway between current levels and BAC’s ratio) and also grow its tangible book value by 10% (which can easily be done as WFC had to turn away business due to asset cap), this would imply a conservative target price of roughly $60, implying ~30% upside from its current price.

You can also juice returns by using long-dated call options (LEAP’s). For example, $50 strike calls expiring Jan 2023 are currently trading for between $6 to $7, and would be a double if WFC hits my $60 price target. Not bad for a boring “boomer” bank stock!

Note: I personally invested in WFC Jan 2023 call options last year (with varying strike prices) and am sitting on 150-200% gains so far.

WFC isn’t quite the slam dunk it was in 2020 when it traded for less than 1x P/TBV, but this turnaround story still has some juice left in the tank and also has a high likelihood of hitting my target, vs. some of my other picks with higher upside but also greater downside/risk.

Please post your reactions & questions below in the comments section!

---

Top Under-the-Radar Investment Blogs to Follow:

• From 100K to 1M:

• Charioteer Investing

• Buck on Software

• Grahamian Value

• MacroValue

• Investment Talk