Wells Fargo & Co (NYSE:WFC) is also a durable business because its loan book is conservatively managed and its revenue sources are well diversified. The company recorded a very low level (0.33%) of net charge-offs as a percentage of total loans in 2015, and its Common Equity Tier 1 ratio of 10.7% is well above the regulatory minimum required for well-capitalized institutions.
Buffett’s ownership of the stock is another vote of confidence in how management runs the business. In his 1990 shareholder letter, Warren Buffett wrote the following about investing in banks:
“The banking business is no favorite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity…Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a “cheap” price. Instead, our only interest is in buying into well-managed banks at fair prices.”
Wells Fargo’s management team clearly checks his boxes to make the company his largest equity stake. As we mentioned earlier, it’s also comforting to know that Wells Fargo maintains a nice revenue balance between interest income and non-interest income. This helps the overall business perform better across various economic cycles.
Overall, we believe Wells Fargo has a large moat. The company gains competitive advantages from its substantial scale, low-cost deposit base, strong capitalization, leading market share positions, and conservative management team. We expect Wells Fargo to be around for a long time to come.
Wells Fargo’s Key Risks
Bank stocks are more challenging to analyze than most other types of businesses because it’s hard to understand what is really going on with their balance sheets and financial health, which are the result of numerous subjective accounting assumptions made by management.
In other words, things usually look fine…until they don’t.
When you think about how a bank makes money, it takes in deposits and lends them out at higher interest rates. To earn an attractive return on equity, banks take on financial leverage to magnify their profit margins.
As long as people and businesses feel safe putting their money with the bank and the bank’s customers continue making their interest and principal repayments on their loans, the bank mints money.
However, banks’ leverage cuts both ways. When delinquencies rise and loans can no longer be paid, a bank’s equity can quickly be wiped out.
To use a simple example, suppose a bank makes a $100 loan to a manufacturing business. To fund the loan, the bank uses $96 of deposits on hand and contributes $4 of its own capital. If the manufacturer is unable to repay its entire loan and only pays $97, the bank’s capital will be hit first instead of depositors’ money. In this case, the bank would see 75% ($3) of its capital wiped out.
If things get really bad, a poorly managed bank that took too much risk can be completely wiped out. This is a simple explanation of what happened during the housing crisis when consumers could not make their mortgage payments and banks had taken on far too much financial leverage and credit risk.
Wells Fargo has proven to be a conservative lender and benefits from having many sources of non-interest income, so we don’t worry so much about this risk. However, some investors are concerned about the impact that nonperforming oil & gas loans could have on banks. Fortunately, these loans account for only 2% of Wells Fargo’s total loan portfolio, and the company has already marked down the value of many of them.
In addition to energy sector weakness, banks are impacted by economic growth and interest rates. Simply put, loan growth is stronger when consumers and businesses are healthier, and net interest margins generally expand as interest rates rise. In today’s sluggish environment, interest margins and loan growth remain suppressed.
