Wells Fargo represents an
opportunity to take advantage of a company that will likely be able to profit
from its position as one of the “last big banks standing.” In fact, some
evidence indicates that this is already taking place, as WFC continues to make high-quality
home loans while at the same time taking advantage of low-interest loans from
the government to do so.
At the same time, I believe the
market has seriously overpriced the future volatility of WFC, providing the
investor with a mechanism for unlevered returns in the range of 30 percent.
To take advantage of this
opportunity, an investor can either buy WFC shares at the market and sell an
at-the-money call option out to Jan 2010, or equivalently simply sell a put
option out to Jan 2010, provided that the investor sets aside the money to
purchase the stock should that put be exercised. I will analyze the
covered-call case, as it is simpler.
At current prices, a share of WFC
will cost $29.48 (though it moved lower in the after-hours, possibly offering a
better deal at the start of the new year – it may move still lower because of
the expected close of the Wachovia deal). Selling a call struck at $30 out to
Jan 2010 nets the investor about $7.00. Assuming WFC continues to pay its
dividend throughout 2009 (a reasonably safe assumption in my view), the
investor will also receive $1.36 in dividends, bringing the total cash-in to
$8.36 across 2009.
Assuming that WFC ends 2009 at or
above $30 per share, the investor will then take home $8.36 for every $22.48
invested (because the $7 is received immediately, I do not consider it as part
of the return computation). This represents an annual return of 31 percent, far
above what I would consider a standard “goal” return on a value investment.
Obviously, the key consideration in
this investment is the risk associated with a significant depreciation in WFC
across 2009, so I will devote the remainder of this writeup to that question.
Berkshire has invested heavily in WFC.
As of September 30, Berkshire owned 290,407,668
shares of WFC, for a total investment of about $8.6B. Buffett has stated
publicly that he is adding to the position, and his average purchase price
is above $30 per share. While I am not going to argue that Berkshire and Buffett are infallible, there is
significant evidence historically that following him is an excellent
strategy for outsized returns. Also, I view him as someone uniquely able
to assess the creditworthiness of a bank in this environment.
I believe the tax shield associated with the
Wachovia acquisition provides WFC with significantly more value that the
risk they are taking on with the troubled assets included in the merger. WFC
has estimated it can write down $74B in losses from Wachovia’s loan
portfolio, meaning that assuming WFC manages to continue in business for
the foreseeable future it should be able to shelter around $26B in taxes
from the government, assuming a 35 percent tax rate.
I realize that credit ratings have come under
fire of late, but WFC continues to command a Aaa rating from Moody’s and
AA+ from S&P.
While Wells has been hurt alongside all the
banks by the mortgage mess, they largely avoided the worst of the MBS-related
investments. Additionally, they were able to raise $12.6B earlier this
year to increase the strength of their balance sheet.
The biggest risk across the next for WFC, and
probably all banks, is the recasting of option-ARM mortgages, which they’re
getting largely from the Wachovia deal. Unlike many other banks, WFC has
already accounted for losses associated with these loans in their
projections – they will mark 2/3 of them to market immediately upon the
close of the deal and the remainder over the next three years. Total
expected losses are around $43B, including about 30 percent of the
option-ARM total. I think this is a reasonable, and probably conservative,
estimate given what I’ve seen from other banks.
Perhaps most importantly, it is pretty clear at
this point that the government and/or the Fed intend to keep rates low for
the foreseeable future. This, combined with the government’s determination
to keep the financial system solvent, makes it fairly unlikely that a
strong survivor like WFC will face hardship over the next year.
From a valuation perspective, should
WFC’s stock be trading below $30 at the end of 2009, the investor who purchased
the covered call investment here would be holding stock with a cash cost of
$21.12 per share (assuming you incorporate both the option premium and the
dividend into the purchase price). At that point, assuming no change in the
dividend rate, the investor will be receiving annual dividends of 6.4 percent.
And, without putting too much emphasis
on book-value in an environment where the value of assets is deeply uncertain, the
investor will hold WFC at a market cap of $70.2B versus a book value of about $47B
as of the end of September 2008. Or, from a projected earnings perspective,
using conservative earnings projections of around $2.25 per share, the
investment has a P/E of around 9.4.
I believe the most likely case is
that WFC’s stock is near or above the current levels, meaning that the investor
will walk away with the dividend and the option premium, representing more than
a 30 percent annual return. Worst case scenario is that the investor winds up
owning the stock at a $21.12 price, which is around 60 percent of what Berkshire paid for its holdings.
Current overpricing of volatility risk in options. No other catalyst is really needed, since the market is offering this return at today's prices.