'Banking' on Housing's Recovery
05/06/2013 10:30 am EST
This bank dominates its market space and is building a mortgage funding powerhouse to boot, says Matt Coffina of Morningstar StockInvestor.
I consider Wells Fargo (WFC) the highest-quality of the big US banks, thanks to the simplicity of its business model and low-cost deposit funding. We’re in good company with this investment—Wells is the largest common stock holding of Warren Buffett’s Berkshire Hathaway (BRK.B).
Although Wells Fargo is also a product of merger activity—most recently doubling in size by acquiring Wachovia—we think it maintains an advantage in terms of succession planning over firms assembled more recently.
We view Wells Fargo’s dominant market position as its largest structural advantage. Wells Fargo is now the largest deposit gatherer in major metropolitan markets from Anchorage to Miami, including San Diego, Phoenix, Denver, and Minneapolis, according to Thomson Reuters Bank Insight.
In fact, we estimate that more than one third of the bank’s deposits come from markets in which Wells Fargo is the pre-eminent player, and more than two thirds are gathered in markets in which the company ranks among the top three. Such positioning provides the bank’s customers with unmatched convenience, and provides the firm with a ready source of funds.
Wells Fargo has more than $1 trillion in assets. The company is split into three segments for reporting purposes: community banking; wholesale banking; and wealth, brokerage, and retirement. The company is also a major player in the residential mortgage market, servicing $1.8 trillion in loans.
Low-cost deposit funding accounts for 70% of the company’s funding, and contribute to its narrow economic moat rating. Indeed, Wells Fargo was able to fund its assets at an average cost of only 1.3% during the last ten years, about 20% more cheaply than its closest competitor.
Going forward, we expect the low interest rate environment to weigh on margins, but still expect Wells to have an advantage over peers. If management’s expense-reduction program is successful, Wells Fargo’s combination of low funding costs and efficient operations will be exceedingly difficult for peers to match.
Wells Fargo’s funding advantage allows the bank to achieve an exceptional level of profitability while participating primarily in basic financial intermediation. Loans make up more than half of the company’s assets, while the company’s exposure to trading assets was less than 60% of its tangible common equity balance in 2012.
Wells Fargo isn’t a large derivatives dealer—its notional and net exposures are only a fraction of the size of the figures reported by JPMorgan Chase. In our view, this greatly lessens the probability that a complex exposure will elude the oversight of the firm’s risk managers.
Furthermore, it also reduces the bank’s vulnerability to regulatory changes in the derivative business, such as those required by the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Wells Fargo is aggressively pursuing mortgage business in the aftermath of the subprime crisis, and now controls about one-third of the US mortgage market. These ambitions are not without cost, though. Along with its peers, Wells has been forced to repurchase faulty mortgages and make financial amends for its servicing missteps. We think its mortgage expenses eventually will be surmountable.
Finally, we think Wells Fargo will soon be in a position to begin returning more capital to shareholders via both dividends and share repurchases. Our fair-value estimate is $43 per share.