We recently moved Wells Fargo to the category “Source of Funds”. If we need to buy a new position or add to an existing position and cash is not readily available in your account, we may sell part or all of your Wells Fargo position to raise the necessary funds. For accounts with sufficient cash to fund new holdings, we will continue to hold Wells Fargo for the time being.
Wells Fargo has been in the portfolio for several years. We added it to the portfolio before the infamous account opening scandal. We have continued to own Wells Fargo because we have viewed the scandal as a short-term recoverable calamity.
A recoverable calamity provides an opportunity for investors to buy quality assets at bargain prices.
In the case of Wells Fargo, we believed a new CEO would come in, reset the culture, and get Wells Fargo back to the business of banking. As the cultural issues that helped create the scandal were resolved, shares would stabilize and ultimately move higher.
While we still think Wells Fargo represents a recoverable calamity, their path to a higher share price has been delayed for a variety of reasons.
The scandal dragged on for several years, much longer than we initially expected. Wells Fargo went through a couple of CEOs during this time, faced multiple congressional hearings, and had its asset base growth capped by the Federal Reserve.
The stock price stagnated. And then sold off even more during the recent Covid-19 market panic.
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And its Return on Equity (ROE) fell from 14% to below 10% today.
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Under the latest CEO, Charles Scharf, Wells Fargo again looks like it’s about to turn the corner and it now sports an 8% dividend yield.
So why are we using it as a source of cash?
The main answer is portfolio management. We added Discover Financial to accounts during this sell-off. We’ll talk more about this position in an upcoming dividend letter, but we saw a quality consumer finance company trading at a panic price. In the long run, we think Wells Fargo is worth double its current price. We also think Discover Financial is worth at least double its current price. But we think Discover can realize its underlying value much faster than Wells Fargo can from here.
With the addition of Discover, we felt the portfolio was too heavily invested in the Financial sector. We needed to remove a position, and Wells is our least favorite of the Financial holdings in the portfolio.
Are we selling JP Morgan the highest quality bank right now? No. We always want to trade up to quality companies when we can.
Are we selling BlackRock? The ETF leader in a world shifting more towards ETFs every day? No.
Are we selling Charles Schwab? It is another company with interest rate risk, but it is the leader in the long-term secular growth trend of RIAs and ETFs. The answer is no. We may use Charles Schwab as a tax loss position though.
That left Wells Fargo.
The other reason is the potential for a dividend cut. Wells Fargo’s stock is trading at a level that appears to be pricing in a dividend cut.
During the Q1 2020 earnings, call management said they are comfortable with their current dividend distributions. And if they continue to meet federal reserve capital requirements under CCAR, their dividend is safe.
From Wells Fargo Q1 20 Earnings Presentation
The Federal Reserve may increase its stress tests forcing Wells Fargo to reserve more against potential losses. According to JP Morgan, Wells Fargo has the lowest reserves against Commerical and consumer loans.
Click to enlarge. Data from JP Morgan
If the economic issues from Covid-19 last longer than Wells Fargo’s models suggest and/or the Federal Reserve stress tests require more capital reserve buffers, then Wells Fargo may cut its dividend.
Right now, with the broad economy slowly reopening and the large actions taken by the Federal Reserve, we think the odds favor Wells Fargo not cutting its dividend. Therefore, we did not sell all of Wells Fargo and have only designated it as a source of cash.
