Since its 2016 banking scandal, Wells Fargo (NYSE:WFC) has been on the butt end of some sadly truthful jokes.
“More fake accounts than Tinder… but still can’t get a date.”
Investors haven’t been laughing. Instead, they’ve endured even more losses. Since January, WFC stock dropped 52% as the financial fallout from its 2002-2016 fake-account scandal mounted. Now that its shares are trading at just 0.77x price-to-tangible book, traditional value investors might feel tempted to scoop up as much WFC stock as they can.
It might be a long wait for profits.
Even with its new CEO, former JP Morgan (NYSE:JPM) executive Charlie Scharf, Wells Fargo will take years to turn around. In the meantime, investors would do better to bulk up on higher-quality financials. When Warren Buffett himself is cashing out, it’s time to take a closer look at why.
WFC Stock: From Golden Child to Black Sheep
Older investors might remember the days when Wells Fargo fetched a premium; its shares used to trade at a princely 6.0x price-to-tangible book (P/TB) value. And for good reason.
Between 1990 to 2007, the company generated a 19% return on equity (ROE), almost twice what the median American company earns today. Its dividend payout ratio of 40% also ensured investors received a steady stream of income.
But then came the financial crisis.
Within a year, Wells Fargo’s returns fell to earth as bank regulators forced the firm to deleverage. Its ROE tumbled to just 9.3% as Basel III regulations pushed the bank’s debt-to-equity ratio down to 1.2x. It turns out the Golden Child was successful because of its high leverage. Today, WFC stock languishes at a significant discount to tangible book value.
Cheap, But for Good Reason
Value investors might look at Wells’ 0.77x price-to-tangible book figure and smack their lips in delight. A basic rule-of-thumb in banking valuations is that 10% ROE banks should trade at 1x P/TB. That makes WFC look 30% undervalued.
But there’s one problem: tangible book value relies on trust in a bank’s internal accounting. And WFC broke that trust.
Banks and insurance company balance sheets are a black box to outsiders. Without performing an in-depth audit, investors have no way to know the quality of a bank’s loan portfolio. And apparently, even managers at Wells Fargo have no idea.
In Q2, Wells Fargo posted a massive $2.3 billion loss as coronavirus shutdowns pushed delinquent loans up 34%. The company’s loss provisions were too small, making CEO Scharf’s tagline of “we will get it done” seem rather ill-timed. But don’t blame the novel coronavirus pandemic. That same quarter, JP Morgan posted a 64% gain in net income, blowing Wall Street expectations out of the water.
For Wells Fargo, unexpected loan losses are a warning for investors: tangible book value (despite its solid-sounding name) decreases when banks write off loans. And if a bank fails to budget for write-offs adequately, investors will do it for them by pricing shares below tangible book. Deutsche Bank, for instance, trades at just 0.35x P/TB. Accounting issues also muddy the water. The “big-4” Chinese state-owned banks, long known for their dubious bookkeeping, all trade well below tangible book value.
Still Rowing in Circles
Wells Fargo sits among these black-sheep institutions. And it’s hard for banks to rebuild trust. That’s because, once loan quality starts slipping, it creates a feedback loop (AKA a death-spiral). Banks struggling to hit their income numbers will often begin taking more significant risks to compensate, making future performance numbers even harder to hit and so on.
That’s how Wells Fargo continues to find itself in hot water. Even after getting sanctioned in 2016 for opening millions of fake customer accounts, the company was later caught in a separate scandal in 2018 for aggressive sales in its wealth management business. Even more recently, staff say little has changed. “Workers are still under intense pressure from middle management to get their bonuses,” the Guardian reported in 2019. “Sales teams still lean on workers to push through deal closings as quickly as possible.”
Will a new CEO change things? According to reports from the Wall Street Journal, Scharf has been a divisive figure within the firm, filling top jobs with a mostly white, male group of former colleagues. “He encouraged decisiveness. He mandated more rigorous performance reviews. In some corners of the bank, people call him ‘Chainsaw Charlie,’ according to people inside the bank.”
Can WFC Stock Recover?
To get back on its feet, Wells will need to refocus itself on its key differentiator: its massive 5,389 bank branch network. It’s the largest network of any bank in the U.S. And since retail banking deposits are a bank’s cheapest source of capital, Wells Fargo’s net income will naturally rise as net interest margins go up.
The bank, however, is not particularly efficient. Dividing total domestic assets among its U.S. branches means that each of Wells Fargo’s branch accounts for $326 million in assets. That’s the lowest of the big-4 U.S. banks:
- Wells Fargo: $326 million
- JP Morgan: $439 million
- Bank of America (NYSE:BAC): $485 million
- Citibank (NYSE:C): $1,413 million
Some will say the comparison isn’t entirely fair: other banks also have larger trading and commercial businesses. But that’s just an excuse. Wells Fargo’s efficiency ratio of 66% is still far higher than the 58% average. (A higher ratio means the bank spends more on overhead costs).
Scharf seems aware of these issues and worked to beef up internal controls and improve their technology. The company also is clawing back business in mortgage originations and other non-banking services.
But bank turnarounds can take a decade or more to pull off. Questionable loans made today often take years to show up as delinquent; Standard Chartered (OTCMKTS:SCBFY) is still digging itself out of a hole it fell into in 2015. And most European banks still earn well below their cost of capital from the 2008 financial crisis.
So, if you’re waiting for Wells Fargo to re-rate back to 1.5x or higher price-to-tangible-book, don’t hold your breath. The company’s poor internal controls likely created a pile of bad loans that will take years to mature and lapse. Even for the most patient investors, it’s going to be a long waiting game.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.