Got your attention? The F word we are talking about here is FIDUCIARY.
The Department of Labor (DOL) recently passed the Fiduciary Rule which, among other things, requires that advisors to retirement plans act as fiduciaries. A fiduciary is required by law to act in their clients best interests. This differs from a lesser standard called the Suitability Rule that most stock brokers and financial sales professionals are held to. The suitability standard requires that they recommend suitable investments, however these investments don’t necessarily have to be in the clients best interest.
This may seem like boring minutiae and legalese, but we think a Fiduciary relationship should be the cornerstone of the investment advisor – client relationship. At AMM we act as fiduciaries on all client relationships, and have since the inception of our firm. While the Fiduciary standard doesn’t guarantee great performance, or even any particular level of skill, it does require the person or firm you are dealing with to put your interests first when providing investment advice. An obvious starting point, in our opinion, when hiring an investment advisor.
The Fiduciary rule reminds us too, that Risk is much more than just the probability of permanent capital loss. There are other hidden or not readily observable risks that are often overlooked by investors. Using the example above, hiring a non-fiduciary advisor likely increases your risk of being exposed to advice that is not in your best interest. While this may seem self-evident, we have rarely met with a prospective client who asked whether or not we were a fiduciary.
Another common, but hidden risk is inflation. Most of us are aware of the mathematical concept of inflation. A stamp costs 49 cents today vs. 32 cents 20 years ago – representing an increase of more than 2% per year. However when it comes to decision making people often ignore or, at a minimum, don’t fully comprehend the risk of inflation.
In a recent Wall Street Journal article by Jason Zweig he referenced a classic experiment where people were asked who would be happier: someone who got a 2% yearly raise when inflation was zero or someone who got a 5% raise when inflation was 4%. While the person receiving the 2% raise would be better off in real terms, two-thirds of those surveyed said the person with the 5% raise would be happier. Evidently the “bigger raise” provided a psychological happiness benefit that trumped the real increase in wealth.
Some investors may currently be opting for a “conservative return” in bank CDs or short-term government bonds at rates well below inflation instead of investing in more volatile investments with higher return potential. For investors with short term money this is entirely reasonable, but for investors with a long time horizon they are essentially trading a negative real return for the comfort of limited volatility. As we often say, volatility is not risk. Real risk is the likelihood of permanent capital loss, and long-term investors in cash, CDs and money market are nearly guaranteeing this at current interest rate levels.
The investment landscape is riddled with these psychological minefields, and is one of the reasons we focus so heavily on investor psychology in these periodic updates. For a deeper read on the subjects of behavioral finance and investor psychology we strongly recommend Thinking Fast & Slow by Daniel Kahneman and Your Money & Your Brain by Jason Zweig.
Dividend Stock in Focus
Wells Fargo (WFC): $48.30*
*price as of the close July 21, 2016
For most of Civilization’s history, the size of the economy was pretty much fixed. To become wealthy meant someone else became poor.
Then something changed. As Yuval Noah Harari points out in his book Sapiens: A Brief History of Humankind
“In 1500 annual per capita production averaged $550, while today every man, woman and child produces, on the average, $8,800 a year.”
What spurred this immense growth?
While credit had existed in one form or another since the dawn of civilization, the credit offered was typically small and the rates high. If the economic pie was fixed why lend out large sums of money to bet on future growth?
During the Scientific Revolution, the idea of progress came about. If we invest our resources in research and exploration we will create better technologies and make new discoveries that will increase the sum total of human production. The economic pie can grow and wealth can be created without taking someone else’s slice.
A hopeful outlook on the future allowed people and institutions to believe in and use credit as a means to fund future growth. Credit became more freely available and offered at more reasonable rates.
As much as we love to gripe about banks, they are the institutions that provide the credit to fund our economic dreams.
Wells Fargo started in 1852 to provide banking, financial services, and most importantly credit to one of America’s biggest economic dreams, the westward expansion.
Like all the major banks, Wells Fargo had to cut its dividend during the financial crisis. The cut was necessary to maintain adequate capital reserve ratios as balance sheet write-offs and loan loss reserves increased during the tumultuous time. Since cutting its quarterly dividend down to $0.05 per share in May 2009, Wells Fargo has increased its quarterly dividend to $0.38, a 39.5% compound annual growth rate. In 2014, Wells Fargo’s total annual dividends paid surpassed its pre-financial crisis high.
Catalysts for Dividend Growth and Price Appreciation:
Wells Fargo recently bought several pieces of General Electric’s (GE) loan portfolio including half of GE’s commercial real estate portfolio and their entire railcar services business. The added efficiency of integrating the portfolio should add around $300 million of net interest income. Well’s Fargo’s efficiency ratio on the new portfolio additions should increase too, as they sell other services to its new customer base of around 160,000 relationships. While these customers had previously only had credit deals with GE, Wells Fargo now has the opportunity to expand the relationships with other commercial banking offerings.
The chart below shows Wells Fargo’s wholesale business loan growth including the recent GE asset purchases.
Higher Interest Rates
One way a bank makes money off deposits is the spread between the interest a bank pays on a savings account and the interest received from buying short-term US treasury bills. The interest paid by short-term treasury bill is based on the Fed Funds rate which currently sits at 0.25%. The interest rate banks pay on savings accounts are equally as low and the spread between the two has tightened.
Net interest margin measures the amount of income generated by a bank’s assets to the interest it pays out to its lenders including its savings accounts. The spread between interest paid on savings accounts and interest received from treasuries is one component of the net interest margin. As you can see in the chart below Wells Fargo’s Net interest Margin is at its lowest level within the last 10 years.
When or if interest rates rise, Wells Fargo’s Net Interest Margin should rise too increasing its profitability and increasing the excess capital Wells Fargo can return to shareholders.
High Switching Costs
How often do you switch banks? Do you change checking accounts everytime the bank across the street offers a new incentive? We’re going to assume you don’t. It’s highly likely that you’re still with the same bank where you opened up your very first account. That bank may have changed names over the years as banks consolidated but you personally didn’t change where your account was held.
Even though checking and savings accounts are pretty much exactly the same at every bank, we don’t switch banks when one offers a slightly better deal. Once we’ve set up a bank account it’s a hassle to change. We have to get new checks, new debit cards, establish a new bill pay system, etc. The incentives to change banks has to be large enough to make it worth the effort. It usually isn’t. Customers tend to stick with their banks for a very long time.
Product per Person
The more products a bank customer has with their bank – savings account, checking account, credit card, mortgage, car loan – the higher the switching costs become, and the more profitable that relationship is for the bank. This is true for both retail customers and corporate customers.
The efficiency ratio (Non-Interest Expenses/Revenue) is a way to measure this profitability. It is far less costly to generate more revenue per existing customer than to gain new customers. The efficiency ratio is also a good proxy for how well a bank controls costs in general. The lower the number the better.
The chart below compares Wells Fargo’s efficiency ratio (dark blue line) to the other big banks: Bank of America (BAC), JP Morgan Chase (JPM), Citigroup (C).
Pre-Mortem (Potential Risks to our Thesis):
Continued Low or Negative Interest Rates
The current low-interest rate policy by the Federal Reserve is hurting Wells Fargo’s profitability. After Janet Yellen raised the Fed Funds Rate up to 0.25% from zero in December of 2015, the expectation for more rate increases rose as well. The Federal Reserve had the opportunity to raise rates a few times since then but didn’t.
Now with the fallout of Britain potentially leaving the EU (the referendum is non-binding) hanging over financial markets, the Fed appears unlikely to raise rates anytime soon. Right now markets are expecting that the Federal Reserve won’t raise rates for at least another year.
A continued low-interest rate environment means a continued low net interest margin for Wells Fargo. A lower for longer net interest margin means less capital to return to shareholders through dividends and share buybacks.
After the 2008 financial crisis and passage of the Dodd-Frank Act, systemically important banks are now required to submit a capital return plan to the Federal Reserve for review. If the Federal Reserve doesn’t think the bank is adequately capitalized or well reserved it can cancel the banks’ capital return plan. Essentially all dividend increases and share buybacks must be approved by a third party. It is no longer up to the discretion of the bank.
Wells Fargo is extremely well reserved and capitalized but that doesn’t mean the Federal Reserve will always think so. Future dividend growth may be hampered by the Federal Reserve’s review. A declined capital return plan doesn’t mean Wells Fargo can not pay a dividend or raise it again in the future. It means the bank will have to submit a revised plan and wait for its approval. It’s possible the new plan will not include a dividend raise. This is a short-term setback because Wells Fargo has to submit its capital plan every year. Missing a dividend raise one year can be “caught-up” in the next review.
Higher Capital Ratio Requirements
Banks create value for their owners by making loans against deposits. All banks, regardless of regulations, should hold some equity reserves to protect against potential losses. The more equity reserves a bank has, the lower their returns on equity, all else being equal. The new higher equity reserve ratios required by the Dodd-Frank Act reduce the overall returns on equity that a bank can deliver.
Wells Fargo’s current Return on Equity is 13.6% which is much lower than during previous economic expansionary periods. Low interest rates and a shrinking Net interest Margin play a part in lower returns on equity too.
If the regulators want the systemically significant banks to hold even more equity reserves then the returns Wells Fargo can generate will be lowered further.
Cross Selling Tapped Out
For such a large bank Wells Fargo’s operations and services are pretty basic. It isn’t involved with capital market activities like JP Morgan, Bank of America, or Citigroup. Wells Fargo remains consumer centric. To help reach its level of profitability while staying focused on consumers means Wells Fargo has to sell a lot of extra services and products via cross-selling.
Cross-selling has been a core strategy at Wells Fargo for years. In 2006 their motto for products per customer was, “We’re Over Five! Shooting for Six! Going for Gr-eight!”. In 2016 the average number of products a Wells Fargo customer has is 6.29, however this is down from 6.36 in 2013. While a small decline, if this trend continues or accelerates it will hurt Wells Fargo’s growth and future profitability.
Another issue is that by focusing so hard on cross-selling and incentivizing your employees to sell more you end up with employees engaging in aggressive and borderline illegal activities. The city of Los Angeles filed a civil lawsuit against Wells Fargo last year accusing the company of engaging in “unfair, unlawful, and fraudulent conduct through a pervasive culture of high-pressure sales”. The lawsuit has now attracted the attention of Federal regulators.
Being the source of credit for economic growth puts banks in a favorable operating position in any capitalistic based economy. A well run bank, a bank that doesn’t take big credit risks and can effectively control costs, can exist for a very long time because their product will always be in demand. The Banca Monte dei Paschi di Siena has been in existence since 1492.
Wells Fargo is comparatively young at 164 years old but it has proven itself as an extremely well-run bank. During its short 164 years, it has survived and grown through many tough economic times. Odds are very good too that it will survive the current low-interest rate, increased regulatory environment currently weighing on its stock price. Even if low-interest rates last for a longer time, as currently expected, there is still tremendous value in Wells Fargo and its banking franchise.
Using 2% per year asset growth, return on assets of 1.3%, share reduction of 1% per year, and a P/E ratio of 11, We value Wells Fargo at $60 per share. We think Wells Fargo is potentially worth a lot more if/when interest rates increase.
All previous letters are archived here.