Wells Fargo: A 2008 Scenario

by The Compound Investor

Back in 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 worry 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 to see how Wells Fargo (WFC) did under the various scenarios. It 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 $43.5b 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 $900b 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. Just by way of comparison, the comparable figure in the worst year of the financial crisis was around 2.2%. Note also that the bank is currently experiencing net charge-offs at circa 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 is seen as the most conservative mega-bank stock in America.

Investment Case

Although I only covered the stock a few days back, I’m finding the current valuation more and more compelling. I mean, the San Francisco-based giant should make somewhere in region of $16.5b to $17.5b this year. This is down a bit on last year’s earnings for two reasons. Firstly, the lower interest rate environment. Secondly, the fact that the Fed-imposed an asset-cap that prevents Wells from meaningful growth.

Now, last year the bank went on a massive stock buyback spree. It retired somewhere in the region of 425m shares from an initial share count of 4.6b. As a result, and assuming the bank hits that $17b net profit area I just mentioned, EPS shouldn’t change much. That means net income of around $4.20 per share 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 the bank can’t grow assets until the cloud of the account fraud scandal drifts away. 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. Heck, legal costs alone could do the trick. Anyway, 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. And you could add a few more digits on top of that once the bank can grow its asset base again. This is a bank that, if it faces a 2008 situation again, will remain well capitalized and profitable. Absent that, 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. I’m not sure you can find many superior long-term investment cases in the conservative large-cap universe right now.


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