Wide-Moat Wells Fargo Worth a Look

Wells Fargo WFC is the top deposit gatherer in the United States. Its strategy rests on deep customer relationships, sound risk management, and operational excellence. Successful execution of this strategy over decades has resulted in a wide economic moat, clearly evidenced in the company’s financials. Wells Fargo consistently paid less for balance sheet funding than most of its competitors over the past decade, and it has also generated more revenue per dollar of assets than most peers over time. We attribute this low-cost funding to a loyal base of longtime customers--account closures did not spike during the worst of its sales problems, demonstrating that customers are willing to stick with the bank.

Unlike its major competitors, Wells Fargo is not a top player in the capital markets. Its business model is more akin to a regional bank than to a money center institution. According to the Financial Times, Wells Fargo generates less than half the investment banking fees of companies like JPMorgan Chase JPM, Goldman Sachs GS, and Bank of America BAC, and trading revenue makes up only a small percentage of noninterest income. Instead, Wells Fargo relies on the more stable revenue generated by its brokerage, advisory, and asset-management businesses. It competes to a large extent with regional peers, and its scale advantages should grow in importance as technology and compliance spending increase fixed costs across the industry. For this reason, we believe Wells Fargo deserves a lower cost of capital--and higher multiple--than riskier peers.

Wells Fargo’s sales culture overheated in recent years. Rather than attempting to improve its customers’ financial lives, management chose to increase revenue at all costs, introducing ill-conceived incentive programs for front-line employees. This decision led to widespread fraud and risked relationships and reputation built over decades. However, customers did not abandon Wells Fargo, and we think new programs focused on deepening active relationships will actually generate more revenue--and less wasted employee time--than overly ambitious product sales goals.

A Rare Wide Moat Rating Wells Fargo is a rare U.S. bank with a wide economic moat. Our base-case projections incorporate long-term returns on equity of just over 13%, well in excess of the bank's 9% cost of equity.

The business of financial intermediation is quite competitive. Banks transform the raw material of deposits and other forms of debt into income-generating financial assets. Customers are quite sensitive to price--for the most part, interest rates are set by the market. Thus, the ability to control costs is key to generating excess returns. Many of a bank’s costs are fixed, potentially producing economies of scale. For example, mortgage and credit card lending is concentrated at large banks after years of consolidation. Increasingly, the costs of keeping up with changes in technology and regulation are difficult for smaller banks to bear.

Banks must also control the costs of providing credit. Highly leveraged balance sheets leave little room for error, making underwriting mistakes extremely costly. Occasionally, a bank may specialize in a lending niche to control risk. In any case, a conservative underwriting culture is not a structural advantage, but it is necessary to maintain superior returns. Access to low-cost funding is perhaps the best source of competitive advantage. Banks compete on the basis of convenience, attempting to offer easily accessible branches, superior digital products, and an attractive selection of financial products.

Switching costs also contribute to competitive advantages. The benefits of changing banks often pale in comparison with the time and effort required to do so. Life changes--moves, marriages, and divorces--are often the primary driver of customer defections. Banks attempt to raise switching costs by deepening relationships via multiple products and by providing acceptable customer service.

Finally, banks depend on the regulatory, competitive, and macroeconomic system in which they operate. From a systemic standpoint, we believe the U.S. offers a fair banking environment. Though regulation has become considerably stronger in the past several years, the country still uses a complex and somewhat archaic system of regulation. Furthermore, the company’s banking market is quite fragmented; Wells Fargo must compete with a variety of regional and community banks, as well as large money center institutions. Over the past 50 years, the U.S. banking system has achieved returns roughly in line with its cost of capital, which supports our view of the environment as intensely competitive. Our outlook is more positive from a macroeconomic and political standpoint. 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.

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. Of the company’s tangible assets, 20% are funded by deposits bearing no interest expense. 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. The company has increased its deposit market share to 10% or more in in 21 states. Furthermore, its focus on cross-selling enables the bank to build tight relationships with customers rather than engaging in one-off transactions. Not only does this produce sticky deposits, but it also results in more productive assets. Wells generates more revenue per balance sheet dollar than most peers.

Despite its recent excesses in this area, the cross-selling strategy has allowed Wells Fargo to prosper since the early 1980s. Many competitors experienced far more Consumer Financial Protection Bureau complaints per dollar of deposits than Wells Fargo. Data provided by the company also appears to show that customers are not leaving Wells Fargo for other banks in droves, supporting the thesis that the bank has generated reasonably high switching costs for its depositors.

Switching costs also play a role in the bank’s wealth management, brokerage, and retirement operations. These lines of business--along with commercial lending--lend themselves to long-term relationships, though the company may have to pay up to keep its advisors and salespeople.

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 over the course of an economic cycle.

Though Wells now must hold additional capital as a systemically important institution, the buffers are smaller than those of the complex money center banks against which it often competes.

Dependent on Economy Wells Fargo and other lenders depend to a large extent on the economic situation. High unemployment, low economic growth, a lack of demand for credit, and an unfavorable interest-rate environment top the list of risks for Wells Fargo shareholders. Overly aggressive assumption of credit or interest-rate risk could exacerbate such conditions.

On a company-specific level, banking is a business of trust. Damage to the Wells Fargo brand could result in permanent loss of customers or force Wells Fargo to compete harder on price. As the company grows, it’s more likely that unsavory activity could escape the attention of management, creating the conditions for additional scandals.

Regulatory action is an omnipresent threat in the banking industry. Wells Fargo could face fines, restrictions on its activities, or costly new compliance requirements. Both of the major political parties appear to favor small banks over systemically important institutions, and further actions to hamper big banks are a possibility.

Finally, bank branches are declining in importance as more transactions take place digitally. Though scale and regulatory expertise create barriers to entry, new or existing competitors could take share as the banking industry digitizes, much as Amazon has done in the retail sector.

Wells Fargo’s capital structure is quite sound. The bank’s common equity Tier 1 ratio is 11.7% as of December 2018. Deposits fund about two thirds of the balance sheet. Wells Fargo has also issued roughly $26 billion in preferred stock. The company has slightly derisked its balance sheet in recent years, with risk-weighted assets falling from 75% of total assets in 2013 to 66% in 2018. Credit quality remains excellent. As of December 2018, nonperforming assets accounted for less than 0.5% of the bank’s total balance sheet. We see Wells Fargo’s ample capital and liquidity levels and excellent credit quality as evidence of superior financial health.