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Wells Has Great Dividend Potential

Josh Peters, CFA

Jeremy Glaser: I'm Jeremy Glaser with Morningstar.com. With news this week that Citigroup and Wells Fargo will be repaying their TARP money to the federal government, questions about if they're going to be able to raise their dividend have been on their investors' minds.

Here to discuss this with me is Morningstar DividendInvestor editor, Josh Peters. Josh, thanks so much for joining me today.

Josh Peters: Happy to be here.

Glaser: So do you think there is a chance that either Citi or Wells Fargo are going to start aggressively raising their dividend, now that they're out of the government's thumb?

Peters: Well, this definitely helps, but I think that the first thing that we can do is just dispense with Citigroup. It's hard to even know what the business mix of that bank is going to look like, a couple of years from now.

They have so many big large businesses, inside of that organization, that they'd like to get rid of, that I don't think that that's one you can really own in anticipation of a dividend. Someday maybe, but that's a long way away.

Wells Fargo, on the other hand, is one of the best-run banks in the country. It's done a lot to leverage the crisis to its advantage. So there was a provision in the TARP program that made it difficult, among other things, for a bank that was participating, to raise its dividend. Having repaid these funds, that particular restriction is now lifted.

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Glaser: So what do you think has to happen before Wells will be able to start paying a meaningful dividend again?

Peters: Well, you've got two more things that you've got to contend with. This goes for Wells, which is really in the news today, but it also goes for some of the other really good banks out there, like a BB&T, US Bancorp. And that is that first we want to see the government settle on what capital ratio standards they're going to have for the industry going forward.

We're pretty sure that these are going to go up. The government going to oblige banks to hold more capital in reserve for losses, making it less likely that the government is going to have to come to rescue, at some point in the future. But in order to build up to those higher capital levels, banks will have to retain more of their earnings, until they get to those figures and then reestablish the kind of extra margin that they like to have. So that's step one.

Step two is that we really want to have more clarity into when loan losses are finally going to start to tail off. You might say we're somewhere on the Mt. Everest of loan losses right now, but we're not quite sure that we're on the other side of the peak of the mountain. It's just too foggy.

Perhaps if we start to see a little bit more of a decline, we can say, "OK, we've passed the peak. Earnings are going to be moving up from here." That in turn will also help green light dividend increases.

Glaser: So what would you expect, or what would you say to investors, now, who are thinking of buying Wells? Should they wait for the dividend increase or do you think they should jump in now?

Peters: I think that there's a couple of ways to look at it. If you're coming into the market with new money, it's kind of hard to buy a bank stock right now for income. Wells Fargo, right now, yield is about 0 .7%. That is really not the kind of dividend return that I would typically look for.

But I've owned this stock since 2005. The bank has done pretty well, but like almost every bank in the country, they had to slash their dividend. I still own the shares. Within an income strategy, I'm trying to figure out what to do. The point that I've come to, thus far, has been to say that the dividend is going to be a function, in the long-term, of the bank's earning power.

Wells Fargo's earning power should be higher in the future than it was in the past, because they did such a good job preparing, having enough capital to go around, being able to take advantage of an opportunity, like to acquire Wachovia, managing their credit risks effectively, all the things that make this bank tick. That's going to mean a better future, in all likelihood, for Wells Fargo, and that should mean a much higher dividend.

The difference is that I'm not getting it yet. So what is it going to look like? I think it's going to take a couple of years. I think chances are the dividend payout ratios will be lower for most banks. They might be 30% to 40%, instead of 40% to 60%, which we saw in the last cycle.

But, at the same time, if earnings are higher, we could see Wells Fargo get back to paying out $1.36 a share, which is what it was paying out before the crash, in, let's say, a four- to five-year time frame. That would give the stock a yield more than 5%, on its current price. It's kind of hard to find a dividend to grow fast enough to take its yield from 0 .7 to 5%. So I think there's enough merit in Wells Fargo, for an income investor, who still owns it, to continue holding.

Glaser: So, again, patience wins the day.

Peters: Yes, it's funny how that works, but this thought recently occurred to me. Most of the money that you will make while you own a stock is going to come from holding it. It's not the buying part, it's not the selling part. It's the holding. It's the collecting the dividends, and, in the case of a Wells Fargo, hopefully benefiting from a lot of dividend growth, once things start to clear up.

Glaser: Well, thanks so much for talking with me today, Josh.

Peters: Happy to join you.

Glaser: For Morningstar.com, I'm Jeremy Glaser.