Article Thesis
The banking struggles over the last two months have made many bank stocks, including Wells Fargo & Company (NYSE:WFC), pretty cheap. Famed investor Michael Burry, which generated massive returns during the bursting of the housing bubble, has recently bought into WFC. In this article, we'll look at the pros and cons of an investment in Wells Fargo.
Regional Bank Struggles Have Made Bank Stocks Cheap
About two months ago, a couple of small and mid-sized banks began struggling. Eventually, Silicon Valley Bank (OTC:SIVBQ), Signature Bank (OTC:SBNY), First Republic Bank (OTCPK:FRCB), and Credit Suisse (CS) did either go under or were taken over at bargain prices.
The struggles of these banks were largely tied to massive (non-cash) losses in their portfolios -- when interest rates are rising, as they have been over the last year, then fixed-rate assets such as treasuries experience market value declines. These losses do not necessarily have to be realized, but when deposit outflows force a bank to liquidate assets at current market prices, these losses are realized. With declining equity positions and mounting losses, customers were less eager to hold their cash with these banks, and eventually, these banks suffered from bank runs.
While this can theoretically happen to all kinds of banks, the fallout has been concentrated on a couple of not overly large banks so far, and they all shared that their risk management was pretty weak -- they didn't match the duration of their assets and liabilities very well, for example.
Despite the fact that only a couple of banks have suffered from bank runs so far, all kinds of banks have seen their share prices pull back in the recent past, which includes Wells Fargo:
From recent highs, Wells Fargo's share price has pulled back by more than 20%. The SPDR S&P Bank ETF (KBE) has dropped by more than one-third, and regional banks, represented by the SPDR S&P Regional Banking ETF (KRE), have slumped by a massive 40%+ from this year's highs. Even the broad Financial Select Sector SPDR ETF (XLF), which does not only include banks but also other financial companies such as insurers, has dropped by double-digits from the levels seen earlier this year.
Clearly, many market participants currently don't want to buy into banks or financial companies, and there has been broad selling pressure on all kinds of financial companies, no matter whether those have experienced bank runs or not. Wells Fargo is trading at around $39 today, which is way below the highs of around $60 seen in 2022.
That's not driven by a bad operational performance, however. Instead, Wells Fargo has generated pretty compelling results so far this year. During the first quarter, the bank saw its revenue expand by a huge 18%, driven largely by higher net interest income. That, in turn, was made possible by the fact that Wells Fargo's net interest margin expanded. Interest rate increases by the Fed oftentimes result in expanding net interest margins for banks, and that also held true for Wells Fargo during the recent past. Wells Fargo's net interest margin was 2.16% during the first quarter of 2022 but expanded throughout the year. During the fourth quarter of 2022, the bank's net interest margin had increased to 3.14%. But despite the bank struggles seen during the first quarter, Wells Fargo boosted its net interest margin further, as it expanded to 3.20% during the most recent quarter. While the year-over-year net interest margin expansion of 104 base points may not sound like too much, it has a massive impact on Wells Fargo's results -- net interest income exploded upwards by 45%, from $9.2 billion to $13.3 billion. Whether Wells Fargo's net interest margin expands further during the current quarter is not yet known, but even if Wells Fargo were to just keep the net interest margin stable, that would still be strong, as the company is highly profitable in this environment.
Despite way higher provisions for credit losses -- those rose by $2.0 billion year-over-year, the bank saw its net profit expand by 32% from the previous year's quarter, as Wells Fargo's net profit hit $4.99 billion -- or $20 billion annualized. For a bank that's valued at $140 billion, that's an extremely attractive profitability level.
Bank investors have been worried about deposit levels, as those caused the bank run issues at Silicon Valley Bank and other failed banks. But Wells Fargo's deposit levels look very solid -- at $1.36 billion at the end of the first quarter, they were down just 2%. The bank's deposits remain massively higher compared to the bank's loans, which totaled $950 billion at the end of the first quarter. I thus believe that bank-run worries do not make sense here -- like other major banks, Wells Fargo has a strong deposit base. Due to a potential flight to safety, the major banks including Wells Fargo could actually benefit from the current bank troubles. Due to their too-big-to-fail nature, they could be seen as safer compared to smaller banks, thereby attracting new deposits by risk-averse customers that shift their deposits from smaller banks to the too-big-to-fail giants.
Wells Fargo's revenue growth, primarily driven by higher interest income, bodes well for the future. But so does another recent development: The bank's ability to control its expenses. Despite ongoing high inflation rates that make almost everything more expensive, Wells Fargo has managed to lower its non-interest expenses by 1% over the last year -- which is quite a feat. Of course, the comparison wasn't too hard, as Wells Fargo's efficiency was far from great in 2022 and previous years, mainly due to the lingering effects of its account scandal a couple of years ago. But still, the bank's ability to lower its expenses not only relative to the revenue it generates but also in absolute terms, is appealing. If Wells Fargo keeps its cost controls tight, profitability will remain strong and could improve further, which would be highly attractive.
The profits that Wells Fargo generates are being shared with its owners. While the dividend yield of 3.1% isn't overly high, it's also far from bad -- that's more than one and a half times the broad market's yield. On top of that, Wells Fargo's dividend has grown considerably in recent years, which includes a 20% dividend hike last summer. Of course, dividends are still below the level seen prior to the pandemic, but Wells Fargo is on track to reinstate the dividend over time. I would not be surprised to see the company increase its dividend again this summer, once CCAR results have been announced.
While Wells Fargo offers a safe and growing dividend, even more money is being returned to shareholders via share repurchases. These buybacks lower Wells Fargo's share count over time, thereby driving its earnings per share, cash flow per share, and so on, all else equal. During the first quarter, Wells Fargo spent $4 billion on buybacks, or $16 billion annualized. That makes for a hefty 11% buyback pace -- if the bank keeps that up, its share count will drop rapidly over the coming years. At least as long as the bank's stock remains very inexpensive and as long as capital levels remain sufficient, I believe that the bank should continue to pursue this strategy, as it should create a lot of value for shareholders in the long run.
Against-The-Herd Investor Michael Burry Buys Wells Fargo
During the housing bubble, investor Michael Burry went against the herd and placed bets on a declining housing market after identifying that the market had been irrational. That was a very profitable bet which made Michael Burry (and a couple of other against-the-herd investors) famous.
Michael Burry is still investing in different assets via Scion Asset Management. In a recent 13F filing, Scion Asset Management showed purchases of Wells Fargo stock and some other bank stocks. While we don't know exactly about Michael Burry's reasoning, it looks like he is seeing the market as being irrational again and seemingly has identified an investment opportunity that he finds compelling -- unloved bank stocks.
While there is no guarantee that Michael Burry is right, his track record is encouraging for WFC owners for sure. Add Wells Fargo's strong underlying performance due to cost-saving measures and tailwinds from rising interest rates, an attractive shareholder return program, and a very undemanding valuation -- WFC trades for around 7-8x net profits -- and Wells Fargo looks attractive, I believe.
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