Putting Wells Fargo's Fine Into Perspective

After

We also note that the firings, which occurred at numerous levels, represent just 2% of Wells Fargo’s total employees, and the company has already announced an end to the aggressive retail sales goals that created misaligned incentives. Problems associated with faulty incentives are well known in the business world--observers from Berkshire Hathaway’s Charlie Munger to professors at the Harvard Business School have commented on the subject. While this by no means excuses Wells Fargo’s behavior, it supports our thesis that the company’s culture and management have generally done quite well for both shareholders and customers over time.

Simple Business Model a Key Advantage We view Wells Fargo's dominant market position as its largest structural advantage. Wells Fargo is the largest deposit gatherer in major metropolitan markets across the country. We estimate that more than one third of the bank's deposits come from markets in which Wells Fargo is the pre-eminent player, and more than two thirds are gathered in markets in which the company ranks among the top three. Wells Fargo's long-standing focus on cross-selling helps lock in customer relationships and access to low-cost funding. The bank builds on its funding advantage through efficient operations and solid underwriting, minimizing costs at the same time it maximizes revenue associated with every dollar held on its balance sheet, garnering the firm a wide economic moat.

Interest rate expectations have swung dramatically in recent months. However, we expect rate changes over the next several years to be driven by several factors. Although we expect pressure on real interest rates to persist, we think the resumption of borrowing by U.S. consumers and businesses, the decline of emerging-market savings, and the normalization of monetary policy will drive U.S. short-term rates above 2% by 2020, boosting net interest income. In any case, with almost half of revenue coming from a diverse range of fee-generating businesses, Wells Fargo is relatively insulated from interest rate drama.

On the credit front, exposure to the energy industry--$17.4 billion in oil and gas loans and $24.6 billion in additional commitments--is likely to lead to higher provisioning in 2016 but should not affect our fair value estimate. With $193 billion of equity and $36 billion in annual pretax profits, Wells is well protected against losses.

Wells Fargo's limited involvement in the capital markets has shielded it from trouble in the past. We'd view a big push into investment banking with caution, as cultural and regulatory problems seem to pop up whenever commercial banks and investment banks join forces. We view Wells Fargo's relatively simple business model as a key advantage over more complex peers.

Wide Moat Results in Exceptional Profitability We expect the company to generate pretax, preprovision returns on tangible common equity averaging over 30% over the next five years, providing plenty of protection against potential losses as well as a significant margin of safety should macroeconomic conditions turn out to be less favorable than we expect. Our base-case projections incorporate long-term returns on equity of 13%, well in excess of the bank's 9% cost of equity.

Not only is Wells Fargo highly profitable, but we believe its returns and capital are fairly safe. The balance sheet’s strength is quite good. Wells Fargo has very little in the way of opaque or questionable balance sheet exposures; basic consumer and commercial loans and investment securities make up more than $1 trillion of its $1.7 trillion in balance sheet assets. No categories have grown exceptionally fast in recent years, and no one category exceeds 200% of tangible common equity.

We're also encouraged by Wells Fargo's consistent strategy and management. The company has prospered under a handful of leaders since the early 1980s and has maintained a consistent strategy focused on retail banking and cross-selling over the past 30 years.

We believe this strategy contributes to Wells Fargo's resistance to disruption. Multiple products per customer and an exceptionally strong branch network--Wells Fargo is dominant in most markets it serves--protects it against share loss to low-cost online competitors, as does its presence in commercial lending, which accounts for about half of balance sheet loans.

Wells Fargo's competitive advantage stems from cost advantages and customer switching costs in its core banking operations--which provide a vast majority of profits--and switching costs and intangible assets in wealth management. Wells Fargo's funding costs are its key source of advantage. The company has over $1 trillion in low-cost core deposits that provide virtually free funding.

We think Wells Fargo's low-cost deposit base is partly attributable to its ability to create high switching costs among its customers. Wells has a vast and dense branch network, allowing it to maintain the top share in one third of its markets and an oligopolistic position as the second- or third-largest player in another third. Furthermore, its focus on cross-selling enables the bank to build tight relationships with customers rather than one-off transactions.

Switching costs also play a role in the bank's wealth management, brokerage, and retirement operations. We attribute this to a combination of exceptional revenue-generating ability, economies of scale, and superior expense management. We expect this figure to improve significantly over our five-year forecast period due to a normalization of the interest rate environment and reductions in expenses related to the financial crisis and changing regulatory standards.

List of Risks Is Not Short Wells Fargo will be forced to hold quite a bit more capital as a systemically important financial institution, which could depress returns. In general, the company will be the subject of far greater scrutiny from regulators and politicians than in the past thanks to its newfound size. Management's incentives may also change as the bank begins to compete with money center institutions--Wells Fargo may be forced into riskier lines of business as it attempts to provide similar services to its customers.

The macroeconomic environment is also likely to influence results. An extended period of deleveraging combined with low interest rates could dramatically reduce profitability, much as Japanese financial institutions have experienced for years.

Credit has seldom been a problem at Wells Fargo. The bank successfully navigated severe real estate downturns in California (its largest market) in 2009 and the early 1990s. Most recently, net charge-offs peaked at 2.71% of loans in the fourth quarter of 2009, yet Wells Fargo was still able to report a profit. We have no reason to believe the company has become a more aggressive underwriter in the ensuing years, giving us confidence that credit losses are likely to remain under control in the coming years.

Though Wells now must hold additional capital as a systemically important institution, buffers are less than the complex money center banks against which it often competes. Furthermore, its conservative culture insulates it to some extent from some of the legal problems facing peers. We therefore do not believe the company is at a large disadvantage in terms of regulatory costs.

We like the company's emphasis on returning capital to shareholders--management plans to eventually return a significant majority of earnings to its owners in the form of dividends and repurchases. Although it may take some time to obtain regulatory approval for the full amount, we don't think the company will need to retain much more than a third of earnings to maintain single-digit balance sheet growth, and we expect management to deliver on this goal within three years.