Wells Fargo Stock: Why It Could Continue Its Bull Run Once The Asset Cap Is Lifted

Summary:

• Wells Fargo has submitted a third-party review to the Federal Reserve to lift a $1.95 trillion asset cap imposed after the 2016 fake accounts scandal.
• CEO Charlie Scharf has been addressing compliance issues since 2019, aiming to remove the cap and secure a significant victory for the bank.
• Despite a 2024 jump in shares, executives anticipate the asset cap will remain in place at least into next year.
• The removal of the asset cap is crucial for Wells Fargo’s growth, having paid billions in penalties and facing numerous lawsuits.

Fond memories from the Berkshire Hathaway Shareholder letters

Wells Fargo (WFC) was a consistent staple of the Berkshire Hathaway (BRK.B)(BRK.A) letters starting in the early 2000s after an initial purchase in 1999. Buffett praised the company’s conservative underwriting approach and non-complex loan and deposit composition, which largely comprised of run-of-the-mill retail mortgages and commercial loans. Not huge books of derivatives or investment banking products, just an easy-to-understand bank. US centric with an overweighting towards the West Coast of the United States at that time being that Wells Fargo is from San Francisco, California.

Of particular note was the amazing cross-selling ability that Wells Fargo constantly touted in their annual shareholder reports, which Buffett saw as a position of strength. The bank was apparently able to sign up customers who may have used one type of banking product to various types of other products. I believe at one point, previous CEO John G. Stumpf wanted bankers to aim to get existing clients up to 8 different account types, this would include checking, savings, mortgages, credit cards, lines of credit, brokerage accounts, etc.

This constant push by management, however, had a negative consequence. As bankers became more stressed under the cross-selling pressure, they began to sign up clients for secret accounts that they weren’t even aware of. This large breach of trust resulted in penalties and fines that have been ongoing for years since these dirty deeds were uncovered in 2016. Buffett, who had now become joined at the hip with Wells Fargo, it seemed, jettisoned Berkshire’s position completely between 2017 and 2022.

I, on the other hand, have taken the side of the late Charlie Munger who when asked about Wells Fargo said that a bank like Wells who had been caught was probably less likely than others in the sector to do it again:

Munger chalked the mistakes of Wells Fargo up to old management, noting that they were not “consciously malevolent” or “thieving” but had instead made “a big error of judgment.”

All eyes have been focused on them, so there is less room for error. Enter new CEO Charles Scharf who was previously CEO of Visa Inc. (V) and Bank of New York Mellon (BK). He has muddled through the tail end of the mess created by previous management, hoping to finally have the penalties behind them. Coming into a possible pro-business and development environment that could tilt the scales in favor of lifting their asset cap seems to have the betting market moving more toward the opinion that it will finally happen.

Even though Wells Fargo has been the best performer of the big banks this year, it’s still one of the cheapest, especially when considering that their asset cap may be uncorked. I believe Wells Fargo is a buy.

Year to date performance

What is the asset cap, and why does it exist?

Here is a snippet from Reuters:

Sept 26 2024 Reuters – Wells Fargo has sent a third-party review of its risk and control overhauls to the Federal Reserve as it looks to remove an asset cap imposed by the regulator, Bloomberg News on Thursday, citing people familiar with the matter.

The bank operates under a $1.95 trillion asset cap that prevents it from growing until regulators deem it has fixed problems dating back to the fake accounts scandal uncovered in 2016.

Eliminating the asset cap will hand a major victory for CEO Charlie Scharf, who has been fixing compliance issues since taking the top job in 2019. The bank has paid billions in penalties while being hit with lawsuits from customers and shareholders.

Both, Wells Fargo and the Fed declined to comment on the report.

Shares of the bank jumped 4.4%. Still, Wells Fargo’s executives see the asset cap stretching at least into next year, the report said.

Here is a great synopsis of what the asset cap has done to Wells Fargo when compared to its peers from investing.com :

After the fake accounts scandal of 2016, Wells Fargo has been put under a $1.95T asset cap by US regulators. A bank’s main assets are the loans it lends out to borrowers, in order to earn interest income. And while competitors like J.P. Morgan and Bank of America have long surpassed the $3T asset mark, Wells Fargo has been forbidden from exceeding $1.95T for eight years now. This is the main reason why JPM and BAC stocks have tripled in price over those eight years, while WFC is trading at roughly the same level as in 2016.

Again, just because an asset cap is lifted doesn’t mean that a floodgate of consumers will be rushing to Wells Fargo to fill in the gap between their loan balances and their competition. However, adding another $1 Trillion in loans to Wells Fargo’s asset profile at an industry average net interest margin of about 3% could mean another $30 Billion in net interest income to be had in future years after the cap is lifted. We can see why this prospect would bring a lot of buyers to Wells Fargo stock this year.

Putting that $30 Billion into perspective, that would be a roughly 50% increase in gross interest income on loans.

Wells Fargo revenue exposure

We can see on the deposit side of the balance sheet that Wells Fargo’s business is primarily made up of consumer banking and lending accounts. That is the bread and butter of Wells Fargo and the reason the Buffett once preferred it as a more simple bank. I would put Bank of America (BAC) also in this category, and probably the primary reason for that bank being the replacement for Wells as the top bank in the Berkshire Hathaway portfolio.

I had argued in a previous buy article on Bank of America that diversifying your client base widely is also an added layer of protection. When Silicon Valley Bank or Signature Bank went under, it was mainly because of a focus on higher-end clients that could move a lot of assets all at once. When your customers are spread out amongst every income cohort in America, you have a smaller likelihood of a run on the bank. Yes, you may not be able to profit as greatly from them and need more staff to tend to their needs, but it’s worth it in the long run.

Who cares about yields on “hold to maturity” and “available for sale” securities when rates start to spike, if there’s no possibility of a bank run, then it’s simply a drag on profitability for a short period of time. This is the benefit of client diversification.

Outside of interest-bearing income, non interest “fee” based income is noticeably higher for 2024 versus 2023. Investment advisory fees and trading activity gains in the two-year bull market have helped to make up for some weakness in net interest income margins.

Net interest income margins [NIM]

On the opposite spectrum of trends in fees, we see net interest income margins sliding a bit year over year. In point one on this slide, Wells Fargo still racks this up to more migration to higher-yielding products, namely CDs and high-yield savings accounts. Short-end-of-the-curve savings products like CDs, money markets, and HYSAs have been way more sticky than the market and banks had anticipated.

Right now, the short-term FED rate cuts have not been deep enough to move customers into longer-dated maturities, if anything is they’re moving anywhere, it’s stocks. That being said, the ideal scenario is that short-term rates get cut and longer rates, like the 10-year Treasury for which mortgage rates are built on top, continue to be fairly high. This should increase the margins if loan demand can pick up. This seems to be the trajectory we’re on as investors remain bullish going into 2025 having more appetite for equities than the 10-year Treasury.

Valuations for the biggest banks in the sector using the Graham Number

All data courtesy of Seeking Alpha

STOCK	TTM BOOK VALUE	TTM EPS	GRAHAM NUMBER	Current price
(BAC)	26.39	2.77	40.55	46.36
(WFC)	49.22	4.84	73.21	73.57
(JPM)	95.36	18	196.52	243
(C)	101.91	3.51	89.71	68.64

Click to enlarge

Looking at valuations of the big banks using the Graham Number to evaluate these banks, shows only Wells Fargo and Citi trading at or below their Graham Number, while Bank of America and JPMorgan are over that number. The Graham Number was popularized in the Intelligent Investor and was the point at which price to book times price to earnings does not cross 22.5. Price targets can be built using [Square root EPS X BV X 22.5].

While Citi remains the cheapest on paper, I believe the asset cap removal prospects on Wells Fargo still leave it undervalued even relative to currently being traded at its Graham Number rather than below it due to potential increases in interest income that could happen rather quickly.

Charlie Munger never gave up

As a posthumous notation of how Charlie Munger runs a portfolio, look no further than the Daily Journal Corporation (DJCO). Even after his passing, not much has changed in the portfolio, which remains all banks plus Alibaba (BABA). Although Charlie Munger was not the small media conglomerates’ CEO, he was their Chairman and holdings portfolio manager. Even in the face of turmoil at Wells Fargo, Charlie never flinched.

I was lucky enough to pick up a good amount of shares at the bottom of the Covid crash and still hold them today. It is my largest bank holding and will continue to be. If Warren Buffett had just waited it out, the stock would have surpassed its all-time high and paid lots of dividends to Berkshire along the way.

Risks

On a percentage basis, Wells Fargo still has the largest exposure as a percentage of loans to commercial real estate of the big banks. Here is the most recent quarter’s commentary by Wells Fargo about their commercial real estate loan portfolio:

Our CRE loan portfolio is composed of CRE mortgage and CRE construction loans. The total CRE loan portfolio decreased $9.2 billion from December 31, 2023, as pay downs exceeded originations and advances. The portfolio is diversified both geographically and by property type. The largest geographic concentrations of CRE loans are in California, New York, Florida, and Texas, which represented a combined 48% of the total CRE portfolio. The largest property type concentrations are apartments at 29% and office at 21% of the portfolio. Unfunded credit commitments at September 30, 2024, and December 31, 2023, were $5.8 billion and $7.7 billion, respectively, for CRE mortgage loans and $8.4 billion and $13.2 billion, respectively, for CRE construction loans. We generally subject CRE loans to individual risk assessment using our internal borrower and collateral quality ratings. We had $18.6 billion of CRE mortgage loans classified as criticized at September 30, 2024, compared with $17.5 billion at December 31, 2023. We had $1.1 billion of CRE construction loans classified as criticized at September 30, 2024, compared with $830 million at December 31, 2023. The increase in criticized CRE loans was primarily driven by the apartments property type, partially offset by the institutional property type. We continue to closely monitor the credit quality of the office property type given weakened demand for office space. Loans in California and New York represented approximately 40% of the office property type at both September 30, 2024, and December 31, 2023. Table 13 provides our CRE loans by state and property type.

A few points here, pay-downs exceeded originations, which is good. I think most would agree that less commercial [especially office] is good at this moment in time where refinancing is still very difficult. Second, they do have more loans entering into the “criticized” category. This is not a loan in default, but simply to end users who may be at risk of default in the future. The Office is the area to watch most closely, with 21% of the CRE loan portfolio concentrated there.

Summary

With only Wells Fargo and Citi trading near their Graham Numbers currently for the big 4, I believe those are also the only two big bank stocks to consider for purchase. On one hand, you have the cheap on paper Citigroup that seems to be forever poorly managed and traded that way.

Then you have Wells Fargo, which was once regarded as highly as JPMorgan for their underwriting standards but has incurred self-harm that may finally be corrected with the lifting of their asset cap. If I had to choose, I’d personally choose Wells Fargo. Buy.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of JPM, WFC either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

The information provided in this article is for general informational purposes only and should not be considered as financial advice. The author is not a licensed financial advisor, Certified Public Accountant (CPA), or any other financial professional. The content presented in this article is based on the author's personal opinions, research, and experiences, and it may not be suitable for your specific financial situation or needs.

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