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No. of Recommendations: 12
Pitch a bank for the portfolio[…]

The most obvious candidate is Wells Fargo (WFC)

In 2008 Wells Fargo doubled its size with the purchase of Wachovia, which makes it one of the four largest banks in the U.S. However, amongst its peers its business model is the simplest.

More than one third of the bank's deposits come from markets where Wells Fargo is top dog, with more than two-thirds coming from markets where WFC is in the top three. Consequently, customers can conveniently find branches and cash machines everywhere.

Once this bank snags a new customer their hope, and strategy, is to cross-sell them other services, snaring them further. Got your checking account at Wells? Why not your mortgage? We have brokerage services and how about a business loan too? This successful strategy deepens its customer relationships and makes it harder for them to jump ship due to switching costs and the inconvenience involved. In other words it gives the bank pricing power. This, and geographic spread and penetration, results is one trillion in low-cost deposit funding, which is around 70% of Well's funding.

Well's was able to fund its assets at an average cost of 1.3% over the last decade, about 20% cheaper than its closest competitor. It's this low cost of funds that has allowed the bank to be more risk adverse than some of its competitors. The company has embarked on an expense-reduction program, which if successful, combined with it's low funding costs, will provide a significant tailwind.

Wells Fargo is not a big derivatives dealer. This activity is only a fraction of J.P. Morgan Chase's. This lessens the likelihood of rogue trading and the consequences of any regulatory changes.

Although their deposit base is substantial they are not overly reliant on net interest income. Non-interest income is nearly 50% of revenues which includes investment related fees and commissions and mortgages. WFC now controls about one third of the country's mortgage market, which of course involves some cleanup due to "missteps" during the housing bubble. All the same, Wells Fargo was not the most aggressive mortgage originator during the bubble so mortgage expenses should be manageable.

Wells Fargo is now in the position to return more capital to shareholders via increased dividends and share buybacks. The bank should be in a good position to increase the dividend going forward and meet its goal of eventually returning 50%—65% of its growing earnings to shareholders.

For what it is worth Morningstar considers WFC's stock slightly undervalued; they peg its fair value $43 a share. And, they give them a credit rating of A+.

One the subject of valuation, WFC's P/E is about 10.5 (Value Line) which is on the lower side historically. VL expects an earning's CAGR of 8% over the next 3-5 years and dividend increases to be north of that (well above the rate of inflation) The current payout ratio is conservative at about 31%. Guessing at stock price they expect it to be between $50 and $75 for 2016-18 (based on a P/E of 14). Value Line ranks WFC 3 for Safety (1 is highest). The Safety ranking was downgraded in March '09. As for Financial Strength they give an A (A++ is highest).

As for Value Line's opinion:

Wells Fargo is one of the strongest and best-capitalized operators in the banking industry. After undergoing a battery of Federal Reserve "stress tests", the company recently received approval to raise the quarterly dividend 20% a share for an annualized rate of $1.20. Although the stock is ranked to mirror the broader market in the year ahead, it has above-average total return potential to 2016-18.

Berkshire Hathaway (Warren Buffett) can't get enough of this stock, to the point that it is now Berkshire's largest individual stock holding. They were still buying at stock prices not far south of today's. If Buffett is wrong about Wells Fargo his legacy as a great and storied investor will be in jeopardy, as will Berkshire Hathaway's stock price. There's no doubt he believes Wells to be an exceptional business and investment.

From various sources, and in his own words, Buffett on banks and Wells Fargo:


"I do not worry about the banking system being the cause of the next bubble. In the end it will be something else," Buffett said. "I feel very good about our investment in Wells Fargo."


"They’ve got a sensational mortgage operation. The total mortgage market was at the $3 trillion level not that long ago. If it goes back up to $3 trillion, I hope Wells is going a third of those."

"Wells did the best job of the big players in the mortgage market and therefore they’ve garnered a share as the other fellows have fallen by the wayside."


"I like Wells Fargo better than anything by far. It complicates life when I and buying things as opposed to the Berkshire Hathaway. I get what is left over…I like Wells Fargo better [than JPMorgan]. We have been buying Wells Fargo month after month for a lot of years. Among the big banks, I think it is the best."


"[…]And Wells ... you can't take away Wells' customer base. It grows quarter by quarter. And what you make money off of is customers. And you make money on customers by having a helluva spread on assets and not doing anything really dumb. And that's what they do."

In summary:

Relatively simple business model
Expert at cross selling services to customers
Asset costs lowest in the business
Significant branch saturation
Respected and relatively conservative management
Reasonable valuation
Rising dividend (currently 3%)
Buffett has an all-in bet on this bank

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No. of Recommendations: 5
Thanks for the find, kelbon. Looks like it was the dividend cut during the financial crisis that kept this one off the radar. Given the rest of the bank's measures, it looks healthy enough...

Looking at data from Capital IQ, I see the following:
Debt: $194,551 mm
Equity: $158,991 mm

Net Income, last 12 months: $19,820 mm
Market Cap, $211,904.8 mm

Payout Ratio: 28.2%
Yield: 2.99%

Estimated long term EPS Growth Rate: 7.15%

From a debt to equity ratio, it looks ok. From a payout ratio perspective, it looks fine. From an overall dividend perspective, it did cut its payout in the financial crisis, but it seems to have recovered nicely: . That's much better than some other banks out there. :-)

From a valuation perspective, using the net income & growth rate numbers above, a 15% discount rate, and a 'growth stepdown' process of:
* estimated growth at listed expected pace for first 5 years, and
* estimated growth at 1/2 analysts' pace for next 5 years, and
* estimated growth at 3% in perpetuity after 10 years...

I get a fair value estimate of around $226,357.18 mm, which is a bit above the current market cap, which is a good thing.

All told, I'm still a bit skeptical on my track record with banks, which is why I ended up dialing the discount rate to 15% rather than my typical 12%, but it still passed.

Net -- I think you found a bank that's worth picking for the portfolio. Thank you.

Since your profile doesn't have your real name, in the selection article, I'll acknowledge you as the person that pointed the bank out by referring to you by your Fool handle of "kelbon". If you'd like your real name to appear instead, let me know what it is. If I catch it before I submit, it'll be there, otherwise, I'll put a note in for the editors to adjust after publication.

Best regards,
Inside Value Home Fool
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No. of Recommendations: 3

I can't say my experience investing in banks has been much different than yours, or tens thousands of other people either. For what it's worth I lost enough money with banks to make a difference during the meltdown. With Bank of America, I managed to get out with my original stake intact, but sacrificed years of appreciation. It was ego, empire building, and mismanagement that brought down Bank of America. Though there is a case to be made that in the end they fell on their own sword, and/or were pushed by government. In any case they didn't have their shareholders' well-being in mind. Another bank I owned imploded while I looked on in disbelief.

The one bank I decided to hold believing that it would recover, eventually, was Wells Fargo. Now the stock is making new highs. Wells Fargo's purchase of Wachovia gave me pause, but one of the strong suits of WFC is its management. It seems that they probably made the right "no pain; no gain" call here.

Every generation, or so, there's some kind of real problem with banks of one stripe or another, due to risk-taking and fueled by greed. However, during the long calms between the storms they can be very profitable, and especially so for income investors. History teaches that it can be a high risk activity betting too heavily on go-go financials, but good quality banks can find a place in most people's diversified portfolios, especially if they are dividend-centric. Though, of course there must be hugely successful investors who don't go near "financials."

I'm sure there's many who are shying away from banks because "once bitten; twice shy." This is human nature of course, and the pain and the suddenness of the "bite" is still relatively fresh. However, not all dogs are bad dogs and given some reflection, distance, and active research there's probably no reason to deny oneself the upside of canine companionship.

If you decide to buy Wells Fargo for the portfolio and choose to credit me with the find that's fine. I'm perfectly happy to be known as "kelbon" :) …but, don't blame me if the stock blows up though! (I don't think it will).

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No. of Recommendations: 0
Here's the article:

don't blame me if the stock blows up though! (I don't think it will).
You're starting to get part of what makes this a difficult exercise. It's one thing to invest; it's something else entirely to invest in public...

Inside Value Home Fool
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No. of Recommendations: 1

Looking at data from Capital IQ, I see the following:
Debt: $194,551 mm
Equity: $158,991 mm

Where I run into trouble with banks is debt isn't the same for a bank as it is for other companies, it is their inventory. I deposit money or buy a CD and the bank incurs debt. They turn around a loan that money out paying me something for my trouble and keeping the difference to pay mostly SG&A and some infrastructure cost. What debt is 'debt' and what debt is inventory?

This makes the debt/equity ratio virtually useless during analysis. It is the size and quality of the book plus their risk management of said book that determines outcomes.

"Bank Capital" needs to be discovered. Some folks, including bank stress testers have taken to "Tier 1 Capital" which is equity plus disclosed reserves. "Tier 2 Capital" is most likely where the profits and risks lie and is harder to discover. One can use the "Capital Adequacy Ratio" to take one sniff at the risk profile of the bank. {Tier 1 + Tier 2 / Risk Weighted Assets}. It takes some serious digging and more than a few hours of green visor and +1 reading glasses to dig this data up.

FWIW As an equity holder I don't like Tier 1 Capital as a backstop to my risk. The first thing that goes out the window under stress is equity. Rarely, during work out, do the equity holders get anything. If there was any equity left in the company they likely don't "need" a workout but are going through a voluntary restructuring in which the equity holder still ends up holding the smelly end of a poop stick.

If I ever venture into investing in banks again it will be through debt issue. Dodd-Frank does a very poor job in addressing the next potential crisis and its "organized unwinding" will do me no favors as an equity holder. I'll loan banks money via savings, CD's and bonds.

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Thanks, Jack. Certainly something I should dig deeper into.

Inside Value Home Fool
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No. of Recommendations: 2
Rather than the dog analogy I'd use the tame tiger analogy. You can only say for certain they never bite after they died.

Personally, I'm happy to leave investing in banks to someone who knows what they're doing. As such I'm content to use BRK as a proxy to investing in WFC, albeit just a small part.

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No. of Recommendations: 1
Where I run into trouble with banks is debt isn't the same for a bank as it is for other companies, it is their inventory. I deposit money or buy a CD and the bank incurs debt.

What debt is 'debt' and what debt is inventory?

It's true that deposits go into the "liabilities" column. However, this is a separate line-item than long and short-term debt. What Chuck is referencing is the banks short and long-term debt.

Deposits, rather than a liability (debt), could be considered the bank's "float", or inventory if you like. Sure it's other peoples' money that the bank is a custodian of. But, the banks job is to create a profitable spread and pocket the difference before deposits are redeemed. So, "loans" (money loaned out by the bank) goes under "assets." In the case of WFC about 80% of deposits (liabilities) reappears as loans (assets) on the balance sheet.

Banks do carry hefty debt loads if you compare them to earnings (net profit). In the case of WFC, last year long-term debt was around seven times net profit.

Considering banks, people tend to fixate on book value and share price to book value. However, Buffett has said that this is a mistake as a true measure of a bank's worth are earnings and return on assets. Share price to book, in and off itself, doesn't tell you if a bank's stock is cheap or not …but I digress.

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No. of Recommendations: 1
Mostly just thinking out loud.

Q ending March 31,2013 Q ending Dec 2012

Total deposits 1011 1002 = 3.6% annualized growth
Net Loans 783 782 = 0.5% annualized growth
% of deposits lent 77% 78%

ST Borrowing 60 57 = 24.6% annualized growth
Accrued Expenses 75 76 = -5% annualized growth
LT Debt 126 127 = -3% annualized growth

From the Earnings statement

Total Interest income 11 12
Total Non Interest inc 11 11

Of the above line items on the balance sheet, which carries the greatest risk? Do I include deposits as debt? Do I only include deposits not lent as debt? Is a current ratio or quick ratio useful in analyzing risk? Is the interest coverage ratio viable?

Half of WFC's income is from interest while half is not. How does this compare to its peers? How does this compare to regional or smaller more traditional banks? What are the risks to the interest income stream? What are the risks to the non-interest income stream?

Capital Adequacy Ratio is the new standard being used to assess the risk profile of the company. What is WFC's CAR? It cannot be assessed from the three sheets. There is a "regulatory and agency capital requirements" note but it only deals with tier one capital. By their figures WFC is above the standard required by the Fed.

And Tier one still includes equity a very hard commodity to spend in order to cover ones liquid losses.

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