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Stock Strategist

Higher Valuations, Lower Risk for 2 Big Banks

We think JPMorgan and Wells Fargo are worth more with less uncertainty now.

After updating our projections and accounting for the time value of money, we’ve raised our JPMorgan Chase (JPM) fair value estimate to $136 per share from $112 and our Wells Fargo (WFC) fair value estimate to $52 per share from $45. We also lowered our fair value uncertainty rating for both banks to medium from high, as economic uncertainty from the pandemic has declined. Even with the valuation increase, JPMorgan still trades above what we think it’s worth. Wells Fargo, on the other hand, appears uniquely undervalued in our U.S. banking coverage.

JPMorgan Chase is arguably the most dominant bank in the United States. With leading investment bank, commercial bank, credit card, retail bank, and asset- and wealth-management franchises, it is a force to be reckoned with. The bank's combination of scale, diversification, and sound risk management seems like a simple path to competitive advantage, but few others have been able to execute a similar strategy. Even the best-managed banks are not immune to the occasional stumble, but JPMorgan has seemingly managed to put all the pieces together in a more cohesive and less error-prone way than peers. With the importance of scale only increasing, we think it will be hard for competitors to catch up.

Wells Fargo remains one of the top deposit gatherers in the United States, even after its scandals and an asset cap, with the third-most deposits in the U.S. behind JPMorgan and Bank of America (BAC). Its strategy historically rested on deep customer relationships and sound risk management; being perfectly positioned for the mortgage market after the financial crisis didn't hurt, either. We don't see the boost from the mortgage business ever coming back, and Wells Fargo’s operational competence has been questionable for years, but we still see a bank with the right fundamentals in place and the potential to improve over time.

Cost Advantages and Switching Costs Result in Wide Moats

We believe JPMorgan Chase and Wells Fargo possess wide economic moats based on sustainable cost advantages and switching costs that are consistent with our bank moat framework. JPMorgan is the largest U.S. money center bank by assets and has leading share and operations in almost all of the areas in which it competes. It has one of the leading investment banks in the world, is one of the largest U.S. issuers of credit and debit cards, is one of the top three U.S.-based merchant acquirers, is one of the largest traders of fixed-income, currency, and commodity products globally, is one of the larger global custodians, has one of the larger commercial banking franchises across business sizes, has a leading consumer franchise with products across over 60 million U.S. households, and is also one of the largest asset managers in the world with assets under management of over $2 trillion.

Wells Fargo is one of the largest U.S.-based banks by assets and has leading share and operations in many of the key areas in which it competes. It has the largest retail branch network in the U.S. and is one of the leading deposit gatherers in the country. Wells Fargo is also one of the largest U.S. issuers of credit and debit cards (with particular strength in debit), has one of the leading commercial banking franchises (with particular strength in the middle market), has a leading consumer franchise with products across roughly 70 million consumers and small businesses, and also has significant wealth-management operations. Further, Wells Fargo has the lowest global systemically important bank surcharge among the Big Four, giving it a further structural return advantage from having to hold relatively less capital.

Given their higher capital levels since the crisis, the increasing importance of scale and scope with changes in technology, and robust fee income, we believe both banks will consistently earn returns that exceed their cost of equity through the cycle.

We argue that bank moats are derived primarily from two sources: cost advantages and switching costs. We see cost advantages as stemming from three primary factors: a low-cost deposit base, excellent operating efficiency, and conservative underwriting. Regulatory costs must also be considered. Within the operating efficiency bucket, we see room for economies of scope leading to a cost advantage via lower relative customer acquisition costs. This factor applies primarily to the banks with the largest distributional scale and the largest breadth of products. Both banks’ operating efficiency has generally been close with peers, although this has changed in recent years for Wells Fargo, given the extra expenses associated with its regulatory issues.

JPMorgan and Wells Fargo fared better than many of their peers during the great financial crisis. Overall, we are encouraged by their history of above-average underwriting and risk-taking ability and believe the underwriting culture has likely remained or even improved following all of the reform in the industry since the crisis.

Overall, we believe the banks’ key advantage comes from their scale in certain fixed-cost, fixed-platform businesses, as well as the breadth of products they can offer to clients. This contributes to economies of scale and scope and can create switching costs for customers as they use the banks for more and more products. JPMorgan and Wells Fargo are some of the top issuers of debit and credit cards, where many of the costs of running the platform are fixed and high in nature, leading to the need for scale. This has been borne out in the industry where much consolidation and concentration within the top performers has occurred. The same trend has occurred in the mortgage industry and is occurring for other consumer-based, mass-market products. While all of these segments are strong on their own, we believe there are advantages to combining them all under one banking roof. Also, the largest banks are able to spend the most on technology and have access to unique data on the largest client bases. We believe higher investment in tech platforms that can scale, as well as access to customer data on millions of households, should bolster the banks’ advantages over the longer run.

From a systemic standpoint, we believe the U.S. banking system has improved over the last decade, as capital levels supporting the banking system are at all-time highs. Further, regulation has become considerably stronger in the past several years. The U.S. banking market is quite fragmented, and JPMorgan and Wells Fargo must compete with a variety of regional and community banks as well as large money center institutions, although this fragmentation has gradually decreased since the 1990s. While we view the banking sector as intensely competitive, the largest banks by asset size have generally been able to earn higher returns on equity for the last several decades and still do so today. Our outlook is generally positive from a macroeconomic and political standpoint for the U.S. banking system, as the U.S. is still the world's leading democracy, has increased GDP at a steady pace for years, and maintains the world's reserve currency, all of which contribute to banking stability.

JPMorgan and Wells Fargo are both large enough to be considered global systemically important banks, although JPMorgan has the highest GSIB surcharge at 3.5% while Wells Fargo has the lowest GSIB surcharge of the Big Four at 2%. They are also large enough to be subject to the Federal Reserve's annual stress tests as well as a host of other regulatory requirements, and we don’t see any massive regulatory relief coming for the large money center banks. The stringent capital requirements that the largest banks are held to give us some reassurance that these banks will be able to weather the next economic downturn.

Regulatory and Macroeconomic Risk Exists

An investment in either bank entails a large amount of regulatory and macroeconomic risk. The costs of compliance are high, the banks are large and complex, and they are prime targets of regulators seeking fines and litigants seeking compensation for alleged misdeeds.

The macroeconomic backdrop is another primary risk. Profitability will largely be determined by the interest-rate cycle and the effects of credit and debt cycles, all of which are not under management’s control. Most of their lines of business are economically sensitive. In addition, the banks are subject to the Federal Reserve's annual stress test. Depending on the results of that review, they may be subject to capital return restrictions. If they were required to hold more capital, returns on equity could be affected. Both banks have performed well on the most recent tests, though, and we would be surprised to see issues here in the future.

There is also higher operational risk. Banking is a business of trust, and damage to the brand could result in the permanent loss of customers or force a bank to compete harder on price. The issues with Wells Fargo’s regulators are not over, with no obvious ending date.

We think JPMorgan Chase and Wells Fargo are both in sound financial health. JPMorgan’s common equity Tier 1 ratio was 13.1% as of December 2020 versus a fully phased-in minimum of 11.3%, while Wells’ was 11.6% versus a fully phased-in minimum of 9%.

As of the end of 2020, JPMorgan reported that $697 billion of its $3.4 trillion balance sheet took the form of high-quality liquid assets, giving it a liquidity coverage ratio of 110%. Wells estimates that its liquidity coverage ratio was 133%.

Capital-allocation plans are subject to regulatory approval each year. JPMorgan has generally targeted 30%-35% of earnings devoted to dividends, with the remaining 65% dedicated to buybacks, although the preference is to use as much capital as possible for investing in the business with buybacks considered a secondary option. Wells Fargo has generally aimed for a slightly higher dividend payout ratio than some peers, at roughly 35%-40% of earnings, while about 50% or more has been devoted to buybacks. Buybacks are flexible in response to the amount of excess capital the bank has as well as the internal investment needs of the business. However, regulatory issues and the pandemic-driven downturn have altered Wells’ latest capital plans. Wells Fargo had to cut its dividend to $0.10 a quarter from $0.51 as a result, with buybacks also subjected to payout restrictions. We anticipate that Wells’ earnings will recover enough in 2021 to potentially allow for a dividend raise, although we don't see the $0.51 dividend coming back anytime soon.

Eric Compton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.