My kung fu is stronger than yours

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2019-07-24 08:27:43

There have been many reasons to stay away from big banks in recent years. Not only have these companies delivered horrendous value destruction during the financial crisis in 2008-2009, but the subsequent recovery has been slow and painful. In addition to this, Wells Fargo (WFC) has received lots of well-deserved criticism due to the sales abuse scandals that were reported in 2016.

Nevertheless, investment decisions need to be made by looking through the windshield as opposed to the rearview mirror. Wells Fargo is reporting solid numbers, and the stock is priced at bargain low levels with a total shareholder yield of 15% at current prices. For long-term investors who can handle the short-term uncertainty, the stock looks like a compelling opportunity.

Wells Fargo Looks Undervalued

The industry is going through a challenging phase, the market for financial services is highly competitive and saturated, and banks are being hurt by declining net interest margins in the current economic environment. However, it's crucial to note that Wells Fargo is still making good money in this scenario.

Wells Fargo reported $1.3 in earnings per share for the second quarter of 2019, beating Wall Street expectations by $0.12 per share. Looking at the main trend in earnings over recent quarters, financial performance looks clearly healthy over the middle term.

Source: Wells Fargo Investors Relations

Wells Fargo has a solid balance sheet with a Common Equity Tier 1 ratio of 12%; this is comfortably above the regulatory minimum of 9% and the company's internal target of 10%. Abundant liquidity should provide plenty of resources for the company to continue rewarding shareholders with big cash distributions in the years ahead.

Speaking of which, the bullish case for Wells Fargo looks particularly compelling when considering valuation levels through dividends and buybacks. The company has been returning lots of capital to shareholders in recent years. Last year alone, Wells Fargo repurchased almost 9% of its shares outstanding, and future cash distributions look even more attractive.

Wells Fargo's new buyback program is for $23.1 billion. In comparison to the company's market capitalization value of $205.4 billion, this represents a share buyback yield of 11.2%. In addition to this, the company has a forward dividend yield of 3.8%, which provides a total shareholder yield - dividends plus buybacks - of over 15% at current levels.

All the big US banks are trading at attractive valuation levels, but Wells Fargo also looks attractively valued in comparison to peers. The table below shows the price to earnings ratio, dividend yield, and shareholder yield for Wells Fargo versus Bank of America (BAC), Citigroup (C), and JPMorgan (JPM). Wells Fargo comes out as the cheapest stock in the group across the 3 indicators considered.

PED YieldS YieldWFC9.53.87%15%BAC10.52.03%13%C9.92.87%13%JPM11.63.15%11%

Data Source: Seeking Alpha Essential and SEC fillings

When Big Buybacks Produce Superior Returns

There is a lot of discussion among investors regarding the pros and cons of stock buybacks. As it usually happens, you need to take a look at each specific case to tell if buybacks are creating or destroying shareholder value.

When a company is repurchasing stocks, it is basically investing in its own shares, so it all depends on the business fundamentals and the price of the stock in comparison to those fundamentals.

If the business is solid and the stock is undervalued, then it makes sense for investors to consider buying the stock in the market. In this case, a buyback program makes the investment thesis even more attractive, as the company is investing its capital in an asset with promising expected returns, meaning its own shares.

Conversely, if the stock is overvalued, there is no reason for investors to buy it at all in the first place. In this case, buybacks make the investment even less compelling on the long side, because the company is allocating capital to an asset with mediocre potential.

In the words of Warren Buffett:

When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.

Statistical research has proven that companies that make big buybacks tend to do them at attractive valuation levels, and those stocks also tend to deliver market-beating returns. According to an article from Patrick O'Shaughnessy, buybacks that account for more than 5% of shares outstanding in a year have a positive impact on investment returns. These buybacks are on average conducted at below-average valuation levels, and the average stock making a high conviction buyback tends to outperform the market by 3.3% in the subsequent year.

Based on this data, it makes sense to pay close attention to companies making big buybacks, especially if the stock is trading at attractive valuation levels. In the case of Wells Fargo, it's hard to argue against the fact that the stock is cheap and the company is repurchasing massive amounts of stock.

Risk, Reward, And Opportunity

The sales abuse scandals have produced a lot of damage to the company's reputation in 2016. But those scandals are already in the past, and Wells Fargo now has a new management team and a renewed incentives scheme. You can never know for sure, but the most likely scenario is that Wells Fargo will not make that same mistake again.

Importantly, the bank did not suffer much in terms of deposits loss due to these scandals, which reflects well on the company's ability to retain customers even under the most challenging conditions. Growth opportunities are scarce for big players in the banking industry, but customer loyalty is a key strategic asset for Wells Fargo.

Macroeconomic conditions regarding variables such as interest rate spreads and the credit cycle have a huge impact on the banking industry. Management can't do much to control those macroeconomic variables, and there is plenty of uncertainty on that front in the current environment. Regulatory pressure and the potential for legal litigation are an additional risk factor for big banks in general and especially for Wells Fargo in particular.

Nevertheless, those risk factors are already well known by the market and incorporated into the stock valuation. In fact, we could say that the market is giving those factors too much weight. At the end of the day, Wells Fargo is a solid business generating strong profitability and rewarding shareholders with enormous cash distributions.

It's hard to tell how the stock will perform in the short term, but downside risk should be limited at current valuation levels, and the stock could deliver big gains if the 15% shareholder yield turns out to be attractive enough to attract more investors to Wells Fargo.

Statistical research has proven that stocks and ETFs showing certain quantitative attributes tend to outperform the market over the long term. A subscription to The Data Driven Investor provides you access to profitable screeners and live portfolios based on these effective and time-proven return drivers. Forget about opinions and speculation. Investing decisions based on cold hard quantitative data can provide you superior returns with lower risk. Click here to get your free trial now.

Disclosure: I am/we are long JPM. 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.

Additional disclosure: I may initiate a long position in WFC over the next 72 hours. Andres Cardenal, Cfa
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