2023-11-28 20:36:13 ET
Summary
- Investing in bank stocks is currently out of favor, due to concerns about weak lending activity, deposit beta, and credit impairments.
- Against negative sentiment, value investors see likely an opportunity to buy undervalued banking stocks, including Wells Fargo.
- Higher interest rates are a strong tailwind for banks' profitability, and Wells Fargo has shown resilience in its loan portfolio and deposit base.
- Overall, supported by strong earnings power and a capital ratio about 180 basis points above the regulatory requirement, I argue WFC stock is a "Buy"
Investing in bank stock is not very popular at the moment, as media sentiment is promoting a multitude of cyclical headwinds, including weak lending activity on recession fears, the expectation of deposit beta cutting into margins, and the likelihood for credit impairments in the corporate loan portfolio. The negative skew towards banks was certainly not helped by the collapse of Silicon Valley Bank and the mighty investment bank Credit Suisse earlier this year.
But while the majority of investors avoid bank stocks, value investors are grateful about the opportunity to buy quality banking stocks at too cheap to ignore prices, and say "thank you" to Mr. Market. One of the most promising opportunities that I see in the financial services industry is Wells Fargo ( WFC ) stock, a blue chip bank that is currently trading at a P/E of below 8.5x on 2024 consensus earnings, and a Price to tangible book value below 1x. Overall, supported by strong earnings power and a capital ratio about 180 basis points above the regulatory requirement, I argue WFC stock is a "Buy".
Since the start of the year, Wells Fargo stock is up less than 3%, compared to a gain of almost 20% for the S&P 500 ( SP500 ), and a gain of about 14% for banking industry leader JPMorgan ( JPM ).
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Interest Rates Are A Strong Tailwind
A core argument why investing in banks stocks is so attractive currently relates to the positive relationship of higher interest rates and banks' profitability. Specifically, I point out that as the Fed funds rate increased from close to 0% in 2021, to more than 5% in 2023, Wells Fargo's net interest income surged by more than $17 billion, to a total of $53 billion for the trailing twelve months leading up to end of September.
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Meanwhile, the higher net interest income is not matched by a higher cost base, as interest income is broadly entangled from labor costs. For reference, Wells Fargo's non-interest expenses only increased by about $2.3 billion from 2021 to TTM 2023, highlighting the benefit of positive operating jaws.
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Investors are concerned that Wells Fargo's spread on interest income may not be sustainable, as deposit beta is expected to cut into margins. However, the latest data does not really support this thesis. Zooming in on Wells Fargo's third quarter of 2023 , I point out that the bank's net interest income has essentially remained flat vs. the June quarter, and remains still above 3%. In that context, it is worth noting that Wells Fargo's net interest income for Q3 exceeded analyst expectations by close to $900 million, according to data compiled by Refinitiv.
Wells Fargo Q3 Reporting
The debate around deposit beta remains a significant topic for bank investors, particularly given Jamie Dimon's Q3 remarks suggesting that banks might be overearning on the NIM spread. However, it's important to note that deposit beta has so far been much lower than what investors, bank managers and equity analysts feared. Furthermore, it is also important to note that rising deposit beta does not necessarily suggest peak Net Interest Margin for banks. In my view, banks could still see favorable impacts on their margins as asset portfolios reprice on higher yields.
In terms of annualized net profitability, Wells Fargo is now well on track to accumulate $18.5 in operating earnings this year (FY 2023), up about 43% YoY compared to the $12.9 billion achieved in FY 2022.
With regard to Wells Fargo's balance sheet, I point out resiliency in the loan portfolio, as well as the broader deposit base. As of Q3 2023, Wells Fargo reported $943.2 billion worth of loans outstanding, suggesting only a $300 million contraction compared to the same period one year earlier. And this headwind in volume was more than sufficiently offset by a 195 basis points jump in yields for the average loan yield (6.23% currently). On a QoQ basis, the loan yield was up 24 basis points. So far, also fears surrounding credit impairments and asset write downs have failed to materialize: The bank's net charge offs on loans has remained in line with historical, cyclically adjusted trends, at 0.36%.
Meanwhile, average deposits decreased approximately in line with the industry trend, by $67.6 billion compared to Q3 2022 (-5% YoY). And most notably, compared to the second quarter of 2023, deposit outflows decelerated to $7.1 billion ($28.4 billion annualized). According to management commentary, this decline in deposits aligns broadly with consumer spending and the shift of customer funds towards higher-yielding alternatives.
Wells Fargo Q3 Reporting
Simply Too Cheap To Ignore
The fundamental backdrop for WFC looks very favorable, in my opinion. But let's try to get a more precise estimate of what WFC stock should/ could be worth. In that context, I consider banks to be prime candidates to be valued with a residual earnings valuation. The RE framework anchors on both the income statement and the balance sheet as well as accrual accounting. As per the CFA Institute :
Conceptually, residual income is net income less a charge (deduction) for common shareholders' opportunity cost in generating net income. It is the residual or remaining income after considering the costs of all of a company's capital.
For my WFC valuation model, I apply the following assumptions:
- To forecast EPS, I anchor on consensus analyst forecast as available on the Bloomberg Terminal 'till 2025. In my opinion, any estimate beyond 2025 is too speculative to include in a valuation framework - especially for banks. Currently, consensus sees WFC's EPS for 2023, 2024, and 2025 at $5.2, $4.9 and $5.4, respectively, according to data collected by Refinitiv.
- To estimate the cost of capital, I use the CAPM framework. I model a three-year regression against the S&P 500 to find the stock's beta. For the risk-free rate, I used the 10y Treasury as of November 25th, 2023. My calculation indicates a fair required return of approximately 10.25%.
- For the terminal growth rate, I apply 2.25% percentage points, which I estimate to be broadly in line, slightly below, expected nominal GDP growth.
Based on the above assumptions, my calculation returns a base-case target price for WFC of $62.34/share.
Analyst Consensus; Company Financials; Author's Calculations
I understand that investors might have different assumptions with regards to WFC's required return and terminal business growth. Thus, I also enclose a sensitivity table to test varying assumptions. For reference, red-cells imply an overvaluation as compared to the current market price, and green-cells imply an undervaluation.
Analyst Consensus; Company Financials; Author's Calculations
A Note On Risks
I'm confident to argue that an investment in bank stocks, particularly Wells Fargo, is less risky than what the market narrative implies. However, it is still important to note that lenders like WFC are exposed to heightened macro tail-risk, especially under severe financial distress akin to the 2008-2009 global financial crisis. More broadly, banks' fundamentals are quite sensitive to economic downturns and fluctuations in interest rates. Challenges related to credit and loan quality could trigger vulnerabilities that might only become evident during an economic recession. That said, although I haven't observed any specific risks that may advise against an investment in WFC as of Q3 2023, it's essential for investors to remain vigilant about the complex dynamics within the broader economic backdrop.
Investor Takeaway
The current sentiment towards bank stocks remains cautious due to concerns surrounding weak lending activity, potential deposit beta impacting margins, and anticipated credit impairments. Recent data, however, doesn't support investor's major concerns for the banking sector; and banks like Wells Fargo continue to generate loads of profits on a supportive interest rate backdrop.
While most investors avoid bank stocks, value investors should definitely find an interesting opportunity in undervalued Wells Fargo stock. Valuing WFC with a residual earnings framework suggests a base-case target price of $62.34/share. Accordingly, Wells Fargo looks like a "Buy" to me.
For further details see:
Wells Fargo: Value Investors Say 'Thank You', Mr. Market