Back in the summer of 2010 then-POTUS Barack Obama signed the Dodd–Frank Wall Street Reform and Consumer Protection Act into law. Though certain elements have since been rolled back by now-POTUS Donald Trump, the stress tests mandated by Dodd-Frank are still ongoing. If you are ever worried about investing in a large US bank stock because of what happened in 2007/08, this is the kind of thing you’ll want to look at.
Anyway, I had a look at the 2019 results just to see how Wells Fargo (WFC) would have held up under the various scenarios. Turns out the bank sails through, even in the absolute worst case scenario. To provide some color to that last part, the Federal Reserve Board modeled what would happen in a severe global recession in which US unemployment ballooned to 10% by the third quarter of 2020.
Real GDP under this scenario was hypothetically seen falling by around 8% from its pre-crisis peak, while the 10-year Treasury yield was modeled as falling to as low as 0.75% as investors rush to the safety of Uncle Sam. Corporate bond yields would spike, and the Dow Jones Industrial Average would crash 50%.
In Wells Fargo’s case, the stress test modeled loan losses worth $43,500m over the two year period starting 1Q19. Around half of the losses would come from corporate loans and commercial real estate. Now, bear in mind Wells Fargo has over $900,000m worth of loans on its balance sheet. Quick math suggests the Fed predicted a loan loss rate of around 4.5% over that two-year stretch. By way of comparison the comparable figure in the worst year of the financial crisis was around 2.2%. (The bank is currently experiencing net charge-offs of just 0.29% per annum).
Some other interesting tidbits. Firstly, Wells Fargo would still have made a couple billion dollars in profit under those conditions. Second, check out what happened to its capital ratios. Assuming it took steps to preserve capital in this hypothetical extreme downturn, Wells would still only have ended up with total leverage of circa 15-to-1. That is actually above where a host of big banks are today, not to mention comfortably ahead of regulatory minimums. At the risk of tempting fate, it’s easy to see why Wells has a tag of being the most conservative mega-bank stock in America.
Although I only covered the stock a few days back, I’m finding the current valuation more and more compelling. I mean over the course of 2020 the San Francisco-based giant should make somewhere in the $16,500m to $17,500m net profit range. This is down a bit on last year’s earnings because of the lower interest rate environment and the fact that the Fed-imposed asset-cap prevents it from meaningful growth.
Now, last year Wells Fargo went on a massive stock buyback spree. Over the course of 2019 it retired somewhere in the region of 425m shares from an initial share count of 4,600m. As a result, and assuming the bank hits that $17,000m net profit range I just mentioned, its per-share profit for 2020 shouldn’t change all that much. That means pegging net income at around the $4.20 per share mark for this year, of which just over $2.00 per share will be shipped out by way of cash dividends. The stock price is currently $47.10.
Even without further investigation that 12x annual profit tag looks appealing. Okay, we know that it can’t grow assets until the cloud of the account fraud scandal has been lifted. Even so, Wells could realistically return around 8% per annum simply by distributing its profit to stockholders. Another thing mentioned in last week’s article was the prospect of freeing up some additional profit via cost reductions (most obviously the legal costs that should abate once the bank gets its house in order). This could well add up to several billion dollars if the bank manages to hit its internal target.
The effect of the above would be to push annual stockholder returns up the double-digit area, all other things being equal. Depending on the future rate of loan growth you could a few more digits on top of that once the bank is finally allowed to grow its asset base again. This is a bank that, if it faces a 2008 situation again, will remain well capitalized and profitable. In the current base case scenario you have a forward 4.3% dividend yield with the realistic prospect of high single-digit annual growth. Quick math implies comfortable double-digit returns, all other things being equal. In the conservative large-cap universe I’m not sure you can find many superior long-term investment cases right now.
If you enjoyed this article please hit the “heart” button below. This gives me a rough indication as to what kind of content is popular. Also, if you would like to get new posts directly to your inbox, feel free to enter your email address in the sidebar and hit the “subscribe” button. Thank you for reading!
Disclosure: I do not currently own shares of Wells Fargo & Company stock but plan to do so in the immediate future.