BUY Wells Fargo: It's Unloved And Undervalued

In markets, patterns repeat. I believe Pattern Matching can be an important part of developing an investment thesis. I highlighted one such investment pattern here: https://playingfordoubles.substack.com/p/interesting-investment-pattern-kws

I believe another pattern can be found by reading John Huber’s (Manager of Saber Capital) investment thesis on Wells Fargo.

John’s Investment Thesis:

1. Wells Fargo is a Very Durable Business.

   • Deposits in the US banking system are very predictable. They have grown for 70 consecutive years, regardless of economic conditions. Wells Fargo gathers these deposits cheaper than just about any other bank, and will continue to do so.

   • Wells Fargo also has a very sticky customer base, which means the company has  very predictable revenues and cash flows. Not many people are willing to go through the pain of switching banking relationships. 

2. Negative Sentiment & Fed Restrictions are Temporarily Depressing the Stock.

   • Negative Sentiment: The company has been facing severe negative sentiment since late 2016 because of it’s account fraud scandal. This was caused by bad incentives which drove bad behavior. This negative sentiment will eventually subside.

   • Fed Restrictions on Asset Growth: Banks make money by pocketing the interest rate difference they lend money at vs the interest rates they pay their customers. As a result, they can increase their earnings by growing their deposit base. However, the Fed has restricted this growth. This restriction should end once the bank proves to the Fed that it has addressed its governance and management issues. This process has already begun.

3. This Stock Represents a Low Risk, But High Return (~15% / Yr) Opportunity.

   • The bank pays a 4% plus dividend and it has also authorized the repurchase of $23 Billion of its own shares over the next 12 months (this represents about 11% of the total market cap of the company - that’s massive!). Over time, the investment should approximate this ~15% “yield”. 

   • Another way to look at it is as follows. The buybacks are likely to continue after 12 months. Therefore, assuming zero growth, the company should buy back north of $40 Billion worth of stock over the next couple of years. This should result in earnings per share of ~6/share. Even if the stock trades at a modest 10 times earnings (P/E), very reasonable for such a predictable and stable business, that represents over 16% annual return.

My Key Takeaways and Thoughts:

1. Negative sentiment can cause even the most well known businesses to trade at significantly below intrinsic value.

2. I completely agree that Wells Fargo is a good, predictable and durable business, which is working through self-inflicted wounds. WFC simply needs to make operational improvements, which are well within their own control. There isn’t anything structurally broken with their business model.  

3. As a result, the bank is a sound financial institution and I am comfortable making the leap of faith that current negative sentiment will eventually subside, and the bank will come out stronger on the other side of it.

4. There is a big margin of safety here as well: No earnings growth is needed to make a very good 15-16% return return. Recall 15% return means your money doubles in only 5 years.

5. The market is completely ignoring any potential upside scenarios. Big returns in the stock market come from revenue growth, margin expansion, and multiple expansion. Wells Fargo has the potential to experience all of these.

   • If the Fed removes its restrictions on asset growth, that should increase revenues and margins.

   • If Interest Rates rise, that should increase WFC margins (they will be able to charge more for any loans they make).

   • If sentiment subsides, it would not be surprising for the multiple to expand. 

6. Wells Fargo, like other major banks, also tend to increase their dividends annually. Due to challenges faced by the bank, WFC’s dividend has increased only ~35% in the past 3 years, whereas Bank of America has increased their dividend by more than 100% and JPMorgan Chase by ~90%. Once WFC gets their house in order, their dividend increases should also be more in line with the other banks, meaning the annual dividend yield based on today’s purchase price should easily reach mid 6% (if not more) in a few years.

7. Share repurchases can manufacture significant increases in earnings per share, if executed well. 

What’s the Investment Pattern Here?

The Investment Pattern here is pretty simple:

1. Find a good business with a predictable revenue stream and steady free cash flows.

2. Find a company with heavy negative headlines/sentiment that has created a big gap between the company’s stock price and it’s intrinsic value. 

3. If you can buy the company at a low price, relative to normal earnings power, and “wait” for the negative sentiment to subside, that can generate a very good return, perhaps even without any expected earnings growth.

What’s Hard About This Pattern?

1. Developing conviction that the business under scrutiny is in fact still structurally sound and durable, and that the negative outlook is indeed temporary.

2. It requires you to buy the stock when sentiment is very bearish, and hence the stock has likely declined in the recent past.

3. Having the patience to wait (likely a few years) until the negative sentiment subsides.

Am I Buying the Stock?

Yes, most likely. 

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Disclaimer: The above content is for informational purposes only. None of the above should be considered investment advice.