Wells Fargo – More Pain; No Gain

Note: This is not intended to be a full investment thesis. This is an update. Feel free to contact me with any questions you may have.

We initiated a position on Wells Fargo in June and increased our position through July. To be fair, “initiated” is somewhat misleading because we owned a minority interest in the company as recently as 2/25/20. Thankfully, we sold as we believed we were early assessing the potential impact of COVID 19. We were right.

Unfortunately, we were wrong to purchase Wells Fargo in the first place. Your manager relied too much on the company’s reputation. In large part because he worships Buffett and Munger, both of whom historically praised Wells Fargo as an institution. Further, I competed against Wells Fargo while at BMO Harris Bank. While people often joked about enjoying competing against Wells, I realized Wells often won deals. Why? At that time much of the answer was the company’s ability to use its balance sheet to win deals.

As of this writing that ability is impaired. Wells Fargo now operates under an asset cap. That asset cap restricts the company’s ability to grow assets from its asset balance on 12/31/17. See https://www.federalreserve.gov/newsevents/pressreleases/files/enf20180202a1.pdf paragraph 5. The Fed imposed the asset cap as punishment for Wells’ flagrent disregard for regulator’s demands.

Unfortunately, our previous position in Wells Fargo was a pretty large one (~7% as of 1/10/20). The stock is down (a) ~65% YTD and (b) ~45% since we sold. If I were you, I’d want to know why I owned the stock now given (a) how poorly the entity performed, (b) how wrong we were previously, and (c) the interest rate environment. The reasons are as follows:

  • New Understanding of the Issues – In March the House of Representatives questioned Charlie Scharf, Wells’ new CEO. Concurrently, both the Republicans and Democrats released reports on Wells malfeasense. While the contents were shocking, a couple things became clear.
    • Wells Fargo’s previous management was not competent. They either lacked the willingness, knowledge, prioritization, or a combonation of the 3 (and then some) to fix the problem. The root of the issue stemmed from Wells’ culture of promoting from within. While this may be perceived as a positive, in Wells case it was a negative because no one in the organization had the necessary background to implment the needed changes.
    • Tim Sloan, the previous CEO, was told multiple times to hire a COO. He never did. Instead, he hired consultants to draft plans, submitted those plans to regulators, and never took any meaningful action to implement the plans. Charles Scharf, on the other hand, came in and hired Scott Powell as COO. Mr. Powell recently cleaned up Bank of Santander’s US consumer business, which suffered from similar issues to the ones Wells Fargo now faces.
  • Continued belief in credit competence – There were plenty of negative comments that surfaced in the documents released by The House. However, not one of those comments was aimed at Wells’ credit culture. Contrarily, it is evident that Wells promoted based on (and highly values) credit competence.
  • Rate uncertainty – While it appears as though rates may never increase, it’s important to acknowledge they may. Further, Wells (and most banks) have alternative ways to generate fee income. While it would be much better if Wells had an investment bank attached to it, determining the outcome of rates on the business is harder than it may appear. One example is mortgage underwriting. When rates decline, mortgage refinancing increases. That drives fee income to Wells, but also reduces current mortgage servicing rights’ value and reduces the rate that drives interest income. However, if home prices increase that interest rate may be applied to a higer asset basse. Thus, interest income may not be as impacted as it appears (though it would certainly get reduced as home price appreciation wont offset the rate decline). That is only one example, but there are many.
  • Price – Assuming $10Bn in losses this year, Wells would generate ~$15Bn/year in net income against a $100Bn market cap. The new management team thinks they can take $10Bn of cost out of the business. Let’s assume that’s aggressive. If they can take $5Bn out the equity offers a ~20% normalized net income yield.

Our success will be tied to Scharf and his team. Scharf, trained by Jamie Dimon, appears to have a good reputation. Some investors ask what he did at BNY Mellon. Two years is not a sufficient time period to make meanungful change in a large organization. Thus, this criticism is not weighted as highly as his tenure at Visa is. Our perception is that Mr. Scharf set Visa up for success today. However, Visa is one of the best assets on the planet; Wells is not. Regardless, Scharf pivoted a strong asset base in the correct direction at Visa. Wells has a lot to envy in it’s asset base. Hopefully, Mr. Scharf assess strategy as well at Wells as he did at Visa.

Time will tell whether the bet on Wells’ turnaround is smart. We will continue to own the business unless two years have passed and the asset cap isn’t lifted. If that happens, we may face a 20-30% permanent impairment of capital. At this position size, we believe we are risking 1.4-2.1% of the portfolio to potentially make at least 7.0%. That is an attractive reward/risk given that we believe the probability of success is greater than 30%.

More importantly, we believe the normalized dividend yield on cost will be quite enticing in a low interest rate world. That dividend yield is actual cash back into our pockets. Given that freedom occurs when cash flow exceeds expenses, this is a bet worth making. We will be rooting for Wells’ ability to generate relatively stable profit in order to support organizational changes.

A reasonable observer would push back on the 30% probability of success assesment. That would be a fair criticism and, to be honest, greater than 30% is fairly arbitrary. That said, it’s evident that Wells has an expense problem more than it has a revenue problem. The expense side of the business is completely out of whack because of all the spending Wells has to incur in order to modernize the bank. Compounding this problem is Wells cannot grow it’s assets until the asset cap is lifted. Unfortunately, “remedying” the problems that led to the asset cap are part of what is driving expenses up.

Importantly, we do not view this entity as a permanently melting ice cube. Rather, we view Wells as a scaled money center bank with very serious temporary problems. Hopefully those problems can get resolved and the entity can focus on growth again. Other banks have dealt with many similar issues already. Ironically, Wells didn’t need to address these issues because it performed so well through the 2007-2009 time period. It’s time for that to change.

Who knows, maybe one day Wells could even have a reasonably competent investment banking arm that would help diversify it away from net interest income. For now, let’s just worry about Mr. Powell getting the asset cap lifted.

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