Financial stocks have had a terrible 2020 so far. Out of all the sectors, financials are right near the bottom of the heap. Wells Fargo (NYSE:WFC) has racked up an astonishing 49% loss year-to-date. Wells Fargo stock didn’t bottom in March during the crash. Instead, it continued slumping into May and has only made the most modest of bounces since then.
The panic creates an excellent set-up for risk-tolerant investors. At this price, Wells Fargo is selling for less than 6 times normalized earnings, and is also offering a nearly 7% dividend yield. That sounds great, but can you trust the bank given its past misdeeds and the current sour economic environment? Here’s what you need to know about the banking giant.
Earnings: More Than First Meets the Eye
In April, Wells Fargo shocked the market with a bad set of quarterly earnings. A lot of big banks reported poor numbers, but WFC really took the cake. Its reported EPS dropped more than 90% as the bank took more loan allowances, saw losses in mortgage servicing and had weakness in profit margins as well.
The company also has been cutting back certain types of lending in response to the novel coronavirus. It axed many home equity loans a month ago. And on Tuesday, the bank announced that it will be cutting off most independent auto dealers from credit as well. This makes sense; the bank needs to protect itself from risky loans as the economy heads south.
Some investors are worried, however, that the company will be losing higher-margin loans as it retrenches. Net interest margin – the key measure of a bank’s profitability – has already been sliding as interest rates drop. A bank gains little from falling rates at this point, as it is already paying nearly 0% for most deposits, thus there is little to save on the cost side. Meanwhile the rate it can charge on home mortgages or short-term loans continues to sink, which compresses income margins. Getting out of riskier – though more profitable – lending will add more downward pressure on the bank’s profitability.
However, Wells Fargo is more protected than investors may realize. The bank has a wonderful deposit franchise, meaning it has access to sticky low-cost funds. It is well-diversified and generates a large chunk of non-interest revenue, boosting profitability. And it is currently facing bloated operational costs relating to lawsuits for past misconduct. These costs will come down over time, revealing the bank’s true profitable core.
Wells Fargo Stock: Is the Dividend Safe?
A huge question around Wells Fargo stock right now is whether it will be able to maintain the dividend. With the share price getting cut in half, the stock now offers a juicy yield. In the past, the company has regularly increased the annual dividend. Though now, with the starting yield so high, even holding that payout steady would be enough to delight shareholders
And, judging from the most recent conference call, the company seemingly has every intention of keeping the dividend intact. Management noted in particular that because it has excess capital now, it is in better position to pay its dividend than it otherwise would be. Remember that, up until the crisis, it had too much money on hand. Thanks to the fraudulent account scandals of a few years ago, Wells’ regulators had prohibited the bank from growing its asset base anymore. As a result, it had to get rid of excess cash via dividends and buybacks rather than reinvesting in new loans.
Wells Fargo was aggressively buying back stock to deal with this; in fact, it was aiming to repurchase around 10% of the float annually. With Covid-19, however, these plans are on hold. The major national banks have stopped their share buybacks, as per regulators’ wishes. Up until now, the bank overseers haven’t made the national lenders cut their dividends. But it’s possible it will come – even the strongest big bank out there, JPMorgan (NYSE:JPM), hinted that it might temporarily reduce its dividend.
So, it’d be premature to say that Wells Fargo’s dividend is 100% secure at this level. That said, I’m confident that Wells will pay as large or larger of a dividend in a few years than it does today. The bank retains a highly profitable core business and plenty of liquidity, despite the scandals and current economic shock.
The Bottom Line for Wells Fargo
This is a rocky time for the banking sector in general and Wells Fargo in particular. Given Wells Fargo’s lousy track record over the past few years, it’s understandable why investors are nervous.
That said, all the pieces are here for a fantastic comeback. It starts with management, and in Charles Scharf, the bank just brought in a superstar CEO. The people responsible for the scandals are gone and the firm was already starting to improve operations before the virus hit. Now, with the recession causing economic upheaval, Scharf has free rein to make major changes with little resistance.
In a few years, we should be looking at a much leaner and more profitable Wells Fargo. The scandal will be gone and legal costs will return to normal, boosting profitability immensely. That will give room to boost the dividend and perhaps even reinstate share buybacks. While earnings reports could continue to be messy for the next year, patient investors will be rewarded.
Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek. At the time of this writing, he owned Wells Fargo stock.