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2019-08-14 22:17:48

Over the past few weeks, markets have been rather volatile as investors worry about trade wars, global recession risks, and falling interest rates. Inevitably, during such sell-offs, certain stocks will get oversold and become good value opportunities. I believe that to be the case for Wells Fargo (WFC), which at less than $46 as of the 8/12 close is hovering within 2% of its 52-week low. While financial stocks have been hit as the Fed begins an interest rate cutting cycle, which will pressure industry net interest margins, WFC is uniquely well positioned among the big banks to weather an economic downturn for three main reasons: its domestic, non-Wall Street focus, regulatory challenges, and large capital returns supported by a fortress balance sheet.

In the second quarter, Wells generated $6.2 billion in net income on over $21 billion revenue. However, investment banking revenue was only $455 million and trading revenue was $1.01 billion, meaning Wells Fargo is the big bank with the least amount of exposure to financial market gyrations, M&A advisory, and new issuance syndication that would be most exposed to a global market downturn. WFC only gets about 7% of its revenue from these activities, so a big slowdown in deal-making or downturn in financial markets will have a far smaller impact on its results than other banks.

While this is a small part of WFC’s business mix, it should be noted that in Q2, the company had 3.5% market share, which was up from the 3.2% in all of 2018. So, while the unit is small, it is doing well. I suspect this is partially due to the fact that Wells’ operations are almost entirely domiciled in the US with US-focused businesses as its customers. Given the US economy’s outperformance relative to Europe in particular, it has faced less of a headwind in investment banking amid the slowing global economy. Ultimately, Wells Fargo’s business profile is more like that of a super-regional, taking deposits and making loans to consumers and Main Street businesses, which should be more insulated from potential Chinese trade headwinds.

Second, Wells Fargo’s regulatory headaches may actually be a positive for the stock, admittedly a contrarian take. Since February 2018, Wells Fargo has not been permitted to increase its total asset size from the $1.95 trillion it had at the time due to its account creation scandal. This regulatory cap has been a headwind for shares to this point because it has severely limited WFC’s ability to increase its earnings power, which is a negative during periods of economic strength. However, by constraining its ability to grow loans, the Fed has effectively limited the ability of Wells to make foolish loans that go bad during recession and cause losses. Consider what would have happened to a bank that was not permitted to increase its mortgage lending from 2006-2008. I bet that bank would have suffered far fewer losses as the housing bubble popped and we went into the Great Recession.

Just by virtue of being unable to grow its asset base, Wells is unable to make the loans that would suffer in a downturn, meaning it will likely outperform fellow banks in a downturn. Indeed, we are starting to see this play out. Over the past year due to the overall asset cap, average loans are up less than 0.5% to $947.5 billion. During this time, nonperforming assets dropped by $1.3 billion to $6.3 billion, meaning the average credit quality of its loan portfolio has improved. Wells has also reduced exposure to riskier loans in markets where there have been more market excesses like autos and commercial real estate to free up capacity to increase its mortgage loan portfolio, which given government guarantees should perform better in a downturn. So in a perverse way, the Fed’s handcuffs on Wells Fargo’s growth leave its balance sheet with less risk than it would otherwise have, paving it to be a winner in a downturn.

Finally, even with these regulatory constraints and small investment banking operation, Wells is still very profitable with a return on equity last quarter of 13%. In addition, Wells has a fortress balance sheet with excess capital. It has a 12% common equity tier 1 ratio vs. the 9% regulatory minimum and 10% internal target. With over $20 billion in earnings power and excess capital on balance sheet, Wells has the capacity to continue returning tremendous amounts of capital to shareholders.

Over the past year, the share count has fallen 8%, and that pace may actually accelerate. As reiterated in the company’s quarterly earnings release, Wells Fargo increased its dividend up to $0.51 a share and initiated a $23.1 billion gross buyback (likely closer to $21 billion after factoring out compensation-related issuance). One benefit of periods of market volatility like this is that large buybacks become more powerful as the company repurchases more shares, more quickly reducing the share count and increasing remaining shareholders’ portion of the company’s earnings power.

At its current share price, WFC could reduce its share count by just over 10% over the next year. This decline in the share count will help protect EPS from lower interest income due to the Fed’s rate cuts while also allowing the company to continue to raise its dividend. Combine a 10% buyback yield with the 4.5% dividend yield, and investors in WFC are enjoying substantial cash returns with the potential for growth down the road when Wells eventually gets approval from the Fed to grow again.

As such, investors looking for value but worried about a further degradation of the macroeconomic environment should consider buying Wells Fargo. It’s domestically-focused, traditional banking operations should protect the franchise better from a global downturn while Fed constraints are actually enhancing credit quality. And investors are collecting healthy capital returns in the form of a large buyback and dividend. I own WFC and would add on further weakness.

Disclosure: I am/we are long WFC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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