Wells Fargo’s Reputation Takes a Hit: Now What?

If there is one thing I have learned about investing in stocks, it is to expect the unexpected.

Life is filled with uncertainty and surprises, and companies in our investment portfolios are no different.

I steer clear of most investment opportunities because they are outside of my (limited) circle of competence.

For this reason, I largely avoid the financial sector because I have no good way of understanding the quality of loans on a bank’s balance sheet or an insurer’s level of underwriting risk.

Given the opaque nature of most financial firms’ financial statements, any investment requires a lot of trust in the management team to appropriately price and manage risk.

Financial leverage used by banks and insurance companies cuts both ways and can be absolutely disastrous when management gets risk wrong (surely no one will ever forget the financial crisis).

Wells Fargo (WFC) is one of the only bank stocks I have been comfortable enough to invest in. I outlined my full thesis on the business here.

I liked Wells Fargo because of its stellar reputation for managing risk, conservative business model (for a bank), and cost advantages stemming from its large base of deposits.

However, Wells Fargo’s reputation has come under pressure over the last week in light of the bank’s illegal actions to open unauthorized customer accounts.

What Did Wells Fargo Do Wrong?

Wells Fargo employees opened over 2 million deposit and credit card accounts that may not have been authorized by customers over the last five years. The company gained $2.6 million in fees from the fraud and was fined $185 million by regulators.

Wells Fargo is known for its cross-selling practices. The company tracks its retail products sold per household in its annual reports, and it clearly maintained an overly-aggressive incentive policy that encouraged many branch employees to break the rules.

Fraudulent activity is inexcusable. The difficult judgment call that needs to be made now is how systemic this issue is across the entire company. As long-term investors, the last thing we want to do is invest our capital with management teams lacking ethics.

At the end of 2015, Wells Fargo had 264,700 active employees including around 100,000 employees in its retail branches.

The 5,300 employees fired by the company over the last five years represent 2% of its total workforce and around 5% of its branch workers.

If the firings were spread evenly over the course of five years, around 0.4% of its total employee base was laid off annually as fraudulent activity was detected.

Wells Fargo gained $2.6 million in extra fees from the fraud, which represents 0.0064% of the firm’s non-interest income last year and 0.003% of the company’s total income.

With over 40 million retail customers (and 70+ million total customers), less than 5% of these customers would have potentially been impacted by the fraud if we assume all 2 million accounts were unauthorized and no customer received more than one fraudulent account.

It seems more likely that multiple unauthorized accounts were given to each impacted customer, which would reduce the potential reach of the fraud to less than 2% of all retail customers.

Don’t get me wrong – I am absolutely not condoning Wells Fargo’s behavior or trying to excuse its horrendous actions. I am just providing a look at the issue in the grand scheme of Wells Fargo’s total operations.

Someone should have detected the incentive plans that led to repeated fraudulent activity. There’s no doubt about that.

However, I also feel it is overly harsh to assume the entire 164-year-old organization is corrupt given the magnitude of this issue relative to the whole enterprise.

The rest of the banking industry isn’t exactly filled with angels either (not that it makes Wells Fargo’s behavior any less despicable). Banks have paid over $200 billion in fines and settlements since 2009. Another article puts the figure even higher. Wells Fargo still remains the “cleanest” of its big bank brothers.

The Senate holds a hearing on Tuesday, September 20, to grill Wells Fargo’s CEO John Stumpf over the fake customer accounts and the bank’s aggressive sales culture.

Beyond that, investors will be watching to see if executive management changes are deemed to be needed, how many customers will switch banks, and what impact Wells Fargo’s decision to (temporarily) scrap its retail sales goals will have on future profits.

Is Wells Fargo’s Dividend Still Safe?

Yes, I believe the firm’s dividend remains very safe. Wells Fargo agreed to pay $185 million to settle with regulators. This amount represents 0.8% of the company’s total net income last fiscal year.

Beyond the fine, we don’t yet know the impact (if any) from current customers leaving the bank and Wells Fargo eliminating its sales goals to reshape its incentive plans.

However, I don’t believe either issue will jeopardize the dividend. Wells Fargo’s payout ratio sits below 40%, which provides a solid margin of safety.

Banks are also much better capitalized than they have ever been as a result of new regulations. Here is what Buffett said about banks in a 2013 interview:

“The banks will not get this country in trouble, I guarantee it. The capital ratios are huge, the excesses on the asset side have been largely cleared out. Our banking system is in the best shape in recent memory.”

I’ll certainly be watching future developments at Wells Fargo over the coming quarters, but I expect the dividend to remain safe, albeit with low growth prospects.

What Will Warren Buffett Do With Wells Fargo?

Wells Fargo has been in Warren Buffett’s dividend stock portfolio since 1989, and I would find it to be very surprising if news on the company over the last week took Buffett by surprise.

The issues weighing on Wells Fargo have actually been in the mainstream news for years. The Los Angeles Times published an investigative report in late 2013 that found the company’s cross-selling sales culture to be very aggressive, resulting in the opening of unauthorized customer accounts in many cases.

Interestingly enough, Warren Buffett applied for regulatory approval to be able to raise his stake in Wells Fargo beyond the Fed’s 10% limit in June 2016. Perhaps the timing was only a coincidence, or maybe Buffett saw an opportunity on the horizon to accumulate more shares at lower prices as the customer account scandal became a bigger deal.

Warren Buffett has remained silent on the current Wells Fargo scandal so far. However, in a recent shareholder letter, Buffett made clear how important reputation is to him:

“As I’ve said in these memos for more than 25 years, we can afford to lose money – even a lot of money. But we can’t afford to lose reputation – even a shred of reputation.”

While Wells Fargo’s reputation has certainly been damaged from its illegal behavior, I would be very surprised if this was reason for Buffett to begin unloading his position.

Buffett invests for the long term and has known Well Fargo’s operations in great detail for decades. Like I mentioned above, I highly doubt this development took him by surprise. If anything, my hunch is Buffett would be more inclined to increase his stake in the bank if the Fed allows him to.

What’s the Worst-Case Scenario?

Top-level executives resign, Warren Buffett looks for a tax-efficient way to reduce his stake in the company, a meaningful number of customers switch over their accounts to competing banks, retail banking sales slow with less cross-selling pressure, regulatory pressures increase, and WFC’s price-to-book ratio drops well below historical norms.

The odds of these factors all playing out simultaneously are very slim, in my view. However, these events could theoretically cause the stock to correct by another 20-30% if investors being to panic and reduce the “safety” premium historically enjoyed by the stock.

Bank stocks trade at a multiple of book value. Companies perceived to have riskier balance sheets and operations usually trade below book value, while banks perceived to be the safest and highest quality trade above book value.

For example, Deutsche Bank, J.P. Morgan, and Wells Fargo currently trade at price-to-book ratios of 0.3, 1.1, and 1.3, respectively.

For more than a decade, Wells Fargo’s price-to-book ratio has never fallen below 0.5. According to Gurufocus, Wells Fargo’s median price-to-book ratio over the last 13 years has been 1.54.

If the company’s price-to-book ratio were to decrease to 1.0, WFC’s stock price would decline to roughly $35 per share, representing a slide of 23%. At that price, Wells Fargo’s stock would offer a high yield of 4.3% and seemingly provide great long-term value for income investors.

Final Thoughts on Wells Fargo

All stocks are risky investments and can result in unfavorable and unforeseen developments – even for a company perceived to be very conservative and disciplined such as Wells Fargo.

“Expect the unexpected” is certainly a phrase that applies to investing, and that is one reason why I prefer to maintain a reasonably diversified portfolio as an individual investor on the outside looking in.

The actions carried out by Wells Fargo’s employees were horribly wrong and should absolutely be punished and prevented from happening again.

Did the company’s CEO and other executives know this scandal was going on? It’s hard to say given the sheer size and scope of Wells Fargo’s operations, but the incentive plans in place clearly placed excessive pressure on employees. Top management is ultimately accountable for having proper controls in place to prevent fraudulent activity.

No one knows what could happen over the next 3-6 months. Headlines could get worse after the Senate’s hearing on September 20th. It’s also too early to know what impact, if any, customers switching accounts and Wells Fargo’s reduced sales goals will have on the bank’s near-term earnings results.

There are enough reasons to see why Wells Fargo’s stock could continue drifting lower, but I would be stunned if WFC ever traded at a price-to-book ratio below 1.0, which would result in a stock price at or below $35 per share (a 23% drop from today). If this were to play out, I imagine Warren Buffett would be licking his chops to increase his stake (if the Fed grants him approval).

The company’s dividend payment remains safe, but it could take some time for the dark clouds to pass over Wells Fargo. For now, I plan to be patient and wouldn’t be opposed to snapping up more shares in the low-$40s.

Market sentiment is unpredictable over short periods of time, but I do not believe the shameful revelations over the past week impair Wells Fargo’s risk profile or long-term earnings power.

Customers will be on higher alert with their dealings with the bank, but I don’t believe that reduces the convenience and cost-efficiency that come with using multiple services from Wells Fargo. Switching over 6+ accounts for Wells Fargo, which is the average accounts per retail household held with the bank, would also be a big pain for customers.

With over 160 years of operational success behind the company, I am willing to give it the benefit of the doubt (for now). My best guess is that this news is behind the company no more than a year from now.