|Shares Out. (in M):||4,400||P/E||0||7|
|Market Cap (in $M):||105,000||P/FCF||0||7|
|Net Debt (in $M):||0||EBIT||0||20,000|
|TEV (in $M):||105,000||TEV/EBIT||0||5|
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Credit conditions are spicy. Are bank stocks priced for the worst case scenario? I don’t know, I just work here. There’s a lot of bank stocks, Wells Fargo is one of them.
On the one hand, almost 10% of mortgages are in forbearance, 25% of small businesses are probably going out of business, laws are rapidly changing in favor of borrowers, and NIMs are under pressure. It’s well established that it’s a prickly time to be a lender.
On the other hand, book multiples are at or near the lows seen in March 2009 and 1991 in many cases. These book multiples have occurred only two (2) other times in the last 30 years.
The regionals are much harder hit but even some of the best banking franchises are trading at historically cheap multiples of tangible book.
The yield curve is trending in the right direction now, unlike 2018 and 2019. Once loan books and deposits finish repricing in the next one to two quarters, NIMs should begin going back up and fundamental momentum could be in our favor for years in the next expansion.
Throughout 2018 and 2019 bank stocks were 40% of Berkshire’s portfolio and Buffett proclaimed that he liked bank stocks compared to other stocks. Buffett’s reasoning was the valuations were better, and banks earn ROEs that are on average better than the S&P average and banks either formulaically return capital or growth with their equity capital. At the Berkshire annual meeting he mentioned that this time banks will be a source of strength for the economy unlike in 2008. Banks have substantially underperformed the S&P since then. If you liked banks at 2x book you’ll love them at 1x book.
Financials are at a low weighting in the S&P.
The Fed and rating agencies have given us some reference points for charge-offs for this cycle. Compared to the last recession, this time the banks are more liquid and well capitalized. The 2020 CCAR stress test includes the usual severely adverse scenario that is similar in severity to the GFC and three covid-19 scenarios which are more severe than the GFC. I think the alternative scenarios if anything are too putative because they assume home prices decline over 25% whereas home prices are actually up 4-5% YOY. Also unemployment peaked at 14% and has already declined to 11%. I suspect we exit 2020 at 6-8% unemployment as Fed surveys indicate that 75% of layoffs since the shutdowns are temporary. At any rate the CCAR scenarios are a well-informed worst case by a very competent regulator. It’s important to note that the CCAR nine-quarter charge-offs exclude any benefit from fiscal stimulus programs.
In most cases the banks are much better capitalized than just before the GFC, due to much more prudent regulation. On my preferred capital ratio, tangible common equity to loans, they are significantly better capitalized because their books are more heavily weighted to treasuries and agencies today than in 2007. I believe the loan books are more responsibly underwritten than in 2007. Given the same variables I think charge-offs would be lower for most well-run banks today than in the GFC. But, it’s likely that some macroeconomic variables will be worse in 2020 than in 2008, especially in the C&I books.
So we’ve established that the situation is hairy, most banks are well prepared for it, and stock prices are discounting a severe outcome. Let’s scribble out what this conflagration might look like for Wells Fargo.
Wells hasn’t released their covid-19 scenarios yet but we do have their 2020 severely adverse scenario. Wells’ nine-quarter charge-off rate in the severely adverse scenario is about 4% compared to 6% for the banking system as a whole. If we extrapolate from the Fed’s covid-19 scenarios (10% cumulative charge-offs), maybe Wells’ covid scenarios will produce something like 6% charge-offs. Let’s further say that fiscal programs mitigate just 1% of that, so 5% charge-offs net of fiscal programs. For comparison I estimate that Wells provisioned 6.5% of their loan book from 2007-2012, with very little fiscal support and inferior loan quality. Wells also released some of these reserves over subsequent years.
Earning assets 1.7T
Non-Interest Inc. 38
Pre-provision EBT 23
Net Income -22
This scenario assumes that the entirety of the nine-quarter losses occur in one year and so pre-provision earnings are unable to absorb all of it. In a nine quarter cadence of course almost all of these losses would be absorbed by pre-provision earnings and would not result in a hit to book value, similar to what happened in the GFC. But it’s completely likely that the bulk of the provisions fall in 2020 since this cycle is going to be fast and furious compared to prior charge-off cycles. Most recessions take one to two years to crescendo whereas this time we’ve hit peak unemployment and income loss in two months. This is attenuated by CECL which frontloads provisions compared to prior accounting rules.
So today we have $31/share of tangible common equity, and after 2020 maybe that’s more like $26. As we observed earlier, Wells bottomed at 1.15x tangible book in March 2009. 1.15x $26 would put a low case stock price around $30. There’s a sensible case that in 2009 NIM was around 4% versus 2.6% today and therefore today’s book is worth less than 2009 book. But at any rate I think that today you’re paying at or below trough book.
What’s the upside? Base case maybe Wells exits 2020 or 2021 with $26 of book, capable of earning a 14% ROE ($3.60 of EPS growing 14% per year), worth $50? Longer term, it’s well established that Wells has one of the worst efficiency ratios in the industry, a full 1000 bps higher than peers. Charlie Scharf has only been in the job for eight months, but he’s signaled that once the company has cleared the oversight process related to their consumer scandals they would begin attacking costs. This is optionality that the market isn’t charging us for today. Arguably Wells’ earnings are worth a premium multiple, and this is why Wells is one of the more interesting bank stocks in my humble opinion.
Cost cuts have been a bull thesis for Wells for quite a while but I think the macro environment may be a catalyst for it to finally happen. Yesterday Wells announced their first major layoffs in the last 10 years. I think this is an important catalyst. I think given the tidal wave of provisions coming it’s irresponsible to maintain this level of waste. I don’t think I’ve ever seen another situation where a company was incinerating $8 billion a year for no apparent reason. Every effort should be made to protect the balance sheet and the first line of defense is pre-provision earnings.
A lot of ink gets spilled about financial repression, low rates, Japan, Europe, and the difficulties facing banks. I would just make a few nebulous observations about all that.
One, I’ve looked at a number of European banks and never bought one because in most cases they have no real tangible equity – it’s mostly deferred tax assets and extend and pretend loans. Tim Geithner and the American banks did an amazing job in the GFC of cleaning out the loan books and recapitalizing in a way that didn’t happen in Europe.
Second, since I’m garbage at macro I just listen to the markets. The bond market is exponentially smarter than me and isn’t predicting deflation and in fact inflation expectations are rising.
One year breakeven inflation:
Five year breakeven inflation:
Commodity markets are perhaps even smarter than bond markets. Copper is rising relentlessly:
The gold/copper ratio was violently rejected off the upper end of a 30 year trend channel. And gold is trading very rich compared to copper by historical standards.
Anyway, these are just some free observations, worth every penny. I suspect that very few portfolios are functionally positioned for rising rates, despite some underlying signs of reflation.
-Provisions peaking in one or two quarters
-Directional improvement in NIMs in one or two quarters
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