Is Wells Fargo Undervalued?
What follows is an example of how we think about investing. It is not a stock recommendation, and the only reason I’m using this as an example is because the firm in question, Wells Fargo & Company, is one of the biggest enterprises in the world with more than $1.2 trillion in assets. Virtually everyone reading this who owns any low-cost index fund or a comparable equity fund through a 401(k) or brokerage account already owns shares of Wells Fargo. There is no guarantee that the entire financial sector couldn’t meltdown tomorrow and bankrupt every major financial firm in the nation. This is the way the world works. You have to do your own thinking and never invest in anything you don’t understand; especially a complex business such as a bank or insurance group.
I am reading the Wells Fargo & Company annual report again for the fourth time this year, as well as conference call transcripts, analysts reports, and a host of other documentation. I’ve been looking at making some additional purchases of Wells Fargo & Company for the long-term holdings through some of my personal retirement trusts and plans, including the only one I discuss on the site, the KRIP portfolio, because I’m convinced the “new” bank, which includes the acquisition of Wachovia during the Great Recession and financial meltdown that doubled the size of the “old” bank, is significantly undervalued. Sure, higher capital requirements mean that return on equity and return on assets will come down from historical levels. That’s fine. But buying into one of the most profitable banking franchises in the world at around 1x book value when the risk of further dilution seems remote is intriguing, to say the least. (Remember, book value doesn’t mean much when a financial firm fails, as I explained in the case study of the downfall of Wachovia).
In other words, it would appear the firm has a profit engine that could result in enormous capital accumulation that, as of now, is barely trickling out of California in the form of dividends and share repurchases as the bank regulators insist these financial firms strengthen balance sheets further. I think the balance sheet is sufficient to avoid punitive equity dilution of any material amount in the future, meaning existing owners should benefit from those profits.
More directly: In an ordinary economy, the earnings power of the new Wells Fargo & Company is so excessive that the current market value would be only 6x or 7x earnings in relation, an earnings yield of somewhere between 16.7% and 14.3% without any growth. By holding the shares through tax-advantaged accounts, when and if the dividend payouts are restored, the cash that flows into my balance sheet will be exempt from a single penny in taxes. If all goes well, 5 or 10 years from now, that stream of dividends will serve as another cash flow source to fund other investments, along with the earnings from candy, soft drinks, insurance, furniture, utilities, wind turbines, trains, oil services, tobacco, alcohol, packaged food, and real estate that have accumulated since I began saving money at 10 years old.
Buying Dollar Bills for Less Than a Dollar
I might be wrong. Even I’m not immune from mistakes. But I think that, as long as we don’t enter another global depression or suffer an enormous macroeconomic disaster, I’m buying $1.00 bills for 50¢ or less. Still, remember the two questions every investor should ask himself or herself before writing a check for an ownership stake in an asset. The second, “If this investment lost 100% of its value, would my standard of living or fortune be wiped out?” is a resounding “no” in my case. I wouldn’t like it, but I’d survive just fine. I’d still have my shares of the private limited liability companies, which generate cash for redeployment, as well as portfolio stuffed with high quality blue chip stock reserves, ownership of highly lucrative intellectual property that pays me royalties on tens of thousands of pages of financial content, some real estate rental income, and other sources of earnings.
If the world continues to recover and the economy is fine in 5 or 10 years, I don’t see how it’s not at least a $60 or $70 stock. If another meltdown occurs and the global economy crashes into a deflationary oblivion, the shares could be at $3 and get diluted by the government. Again, this is just in the nature of equity investment. Someone who can’t live with that shouldn’t own stocks. The defense is to build your portfolio like an insurance company. Some of the policies might go bad but, overall, you hope to put together a collection of policies (assets) that make money; a satisfactory after-tax, net of inflation return on your capital.
I imagine that in the next few years, the news coming out of the banking sector and the banks is going to be brutal and nerve-wracking. I suspect there will be quite a bit of volatility as the market reacts to perceived dangers and the spectre of a European meltdown. But I think the odds, relative to the price, are favorable for a long-term, 10+ to 20+ year holding period. Short of circumstances I currently do not anticipate, I imagine I’ll be a net purchaser of shares.
My Favorite Passages from the Wells Fargo & Company Annual Report
There were a few passages I really enjoyed from the Wells Fargo & Company annual report. I’ve added emphasis to highlight my favorite parts.
The best way to grow capital is the old-fashioned way: earn it yourself internally rather than relying on unpredictable markets. We’ve grown our capital internally at a higher, more consistent rate than any of our large peers because we’ve earned more per dollar of assets than they did.
Our capital position is among the strongest of any large bank in the world, but capital isn’t meant to be hoarded, it’s meant to be used.
The bad news is it’s hard to do. The good news is it’s hard to do, because once you build it, it’s a competitive advantage that can’t be copied. If it were easy, everyone would be doing it.
We will find out if my thesis is correct somewhere between 2016 and 2022. In the meantime, huge fluctuations in the daily quoted value of bank shares is likely to be the norm. In the short-term, I wouldn’t be surprised either way if I woke up to find the stock had collapsed to $10 or skyrocketed to $50.
Generally speaking, I think the fear in the banking sector is overdone. In my opinion, we are nowhere near where we were in 2008 and there are a select, few, very interesting opportunities. There are also a handful of banks that I wouldn’t touch with a 10-foot-pole, but you can figure out which those are by yourself. At one my point, my father was investing in shares of one of those banks, which I teasingly began to refer to as “the black hole” during family dinners, but he asserts he is correct. Time will tell. That is why the two-questioned approach is so important. Follow those rules and even a wipeout from time to time should leave you richer with the passing years. After all, if someone as brilliant as Warren Buffett can generate major losses from Dexter Shoe, you’re bound to make some capital allocation mistakes in your lifetime. It is your responsibility to run your affairs to those mistakes don’t matter.
Image made available due to attribution-sharealike 2.0 generic (cc BY-SA 2.0) creative commons license and published on flickr by saturnism / Ray Tsang as of 10/08/2011)
Update: Three years later, an update was published on Wells Fargo & Company shares held since this post went live.
Update II: Several years ago, I placed this post, along with thousands of others, in the private archives. The site had grown beyond the family and friends for whom it was originally intended into a thriving, niche community of like-minded people who were interested in a wide range of topics, including investing and mental models. I decided, after multiple requests, to release selected posts from those private archives if they had some sort of educational, academic, and/or entertainment value. On 05/22/2019, I released this post from the private archives. This special project, which you can follow from this page, has been interesting as I revisited my thought processes about a specific company or industry, sometimes decades later. In this case, reading about how we approached the analysis of a real-world business was helpful to many of you and the information contained herein is now so old there is no chance a reasonable person might mistake it for current market commentary.
One major change that has occurred in the years since this post was originally published: Aaron and I relocated to Newport Beach, California in order to have children through gestational surrogacy. Within a window of a couple of years around that relocation, we also sold our operating businesses and launched a fiduciary global asset management firm called Kennon-Green & Co.®, through which we manage money for other wealthy individuals and families. That means we are now financial advisors (or, rather asset managers operating under a investment advisory model as we are the ones making the capital allocation decisions rather than outsourcing those to fund managers or third-parties), which was not the case at the time this was written. Accordingly, let me reiterate something that should be perfectly clear: this post was not intended to be, and should not be construed as, investment advice. Also, for the sake of full disclosure, I’ll state outright that Aaron and I still own shares of Wells Fargo & Co. personally and that the stock represents one of the major equity holdings of our firm’s private clients. We express no opinion as to whether or not you should buy it. Any company can do poorly or even go bankrupt. There are no guarantees Wells Fargo will generate a profit or make money for shareholders. We may buy or sell Wells Fargo for ourselves or our clients in the future, or any other bank, for that matter, and have no obligation to update this post or any other historical writing. You should talk to your own qualified, professional advisors about what is right for your unique circumstances, goals, objectives, and risk tolerance.
Stated candidly, this post is a historical anachronism from nearly a decade ago that arose because we weren’t in the asset management business but, rather, were private investors. In the future, things like this will not be posted on my personal blog but, instead, if they are written, released through Kennon-Green & Co., including letters to the firm’s private clients.