Del 13 Abril 2019
Tim mcAleenan, the Conservative income investor.
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The Obvious Undervalued Blue-Chip Stock
It is difficult to find darn good businesses that are trading at prices that offer a good risk/return profile and trading at a price that recognizes the reality that another recession will strike the United States again, and when it does, P/E ratios will collapse.
Two of my favorite businesses, Visa and Mastercard, are trading at valuations that exceed 40x their trailing 12x month earnings. While their brand names and methods of generating profits are possibly the most rapid-growth friendly I have ever seen–they pay a somewhat fixed amount of network and advertising costs, and as the world spends more on digital payments, they come along to collect an ever-increasing override.
Similarly, which was trading in the $51-$54 range when I last wrote about it and purchased shares a few weeks ago, has now risen to over $61 because it has filed for facial recognition patents in the past week that could give it two major sources of extraordinary growth–these facial recognition patents and the future growth of its evidence.com data storage platform–that could boost the firm’s overall growth rate which is already growing quickly with its tasers and body cameras.
Even old standbys Franklin Resources and Anheuser-Busch have climbed from $30 to $36 and $65 to $88, which may not sound like much, but represents price appreciation of 20% and 30% respectively in a short period of time.
Realizing the capital appreciation is nice, and even the ultimate point of stock-market investing, but it does create problems on the allocation side. I have reviewed almost every stock in the S&P 500 to study its performance from 2007 to 2009, and what caused investors to lose 60% to 80% on some investments wasn’t the fact that America’s most profitable companies were suddenly becoming unprofitable, but because the company experienced a dramatic swing from overvaluation to undervaluation.
If a company is worth 20x earnings, a fall to undervaluation of 15x earnings only means you take on a 25% paper loss when the recession occurs. But if a company worth 20x earnings finds itself trading at 30x earnings, and then the same recession arrives that takes it down to 15x earnings, there is a 50% paper loss to endure. I don’t have a sense of entitlement with investing and so I have no delusion that paper losses are a real part of the process, but I remain keenly aware that the biggest risk is when you overpay for a stock because the first 25% of your paper loss may be “justified” as the disappearance of value that never should have existed in the first place rather than a fear-driven moment of irrationality that will subside.
Despite my very high opinion of Visa’s business model, I am not purchasing additional shares right now because it is not inconceivable that a recession could take the valuation of the stock down from 40x earnings to 15x earnings. Conceivably, close to half of that 62.5% possible decline could be the result of excessive enthusiasm for the company’s growth prospects justifiably disappearing. That is why I bought my shares at 20x to 25x earnings per share, continue to stick around as the earnings per share climb, and so any future P/E compression will be tolerable compared to the capital actually deployed to make the investment.
In short, I try to do what I always do–hold the stocks I buy, and add new ones or grow existing businesses when the prices are attractive. And although I do find it quite difficult to find new investments at this price point, especially compared to where we were on Christmas Eve, I do subscribe to the
As much as GE has been through this past decade, someone who bought the stock at $6 in 2009 would own a stock worth $9 now and have collected approximately $6 in dividends over the past decade as dividend. That is a 150% gain while everyone else has been disappointed with the stock over the past decade simply because the stock was purchased at the right price point. It serves as yet another confirmation that the experience of individual investors owning the same stock can be quite different because we all have varying initial price points, and it is the initial price point that determines whether or not we find success.
With all of this mind, I find myself once again turning to Wells Fargo to purchase more shares in light of its decline to the $46 mark and a 3.87% dividend yield after Friday’s earnings results. For what it is worth, when Wells Fargo fell to a 3.87% yield point in 1989, it went on to deliver 13.8% returns to investors during the subsequent thirty years, which included two banking crises. With the exception of Apple, there is a reason why Wells Fargo is the largest amount of capital that Warren Buffett has ever dedicated to a single stock.
The megabank is on track to earn about $5.10 per share in 2019, putting the $46 price tag at a valuation of 9x earnings. What is especially compelling about the bank is that so much capital is retained after dividends are paid out. In my 1989 example, Wells Fargo was paying out 72% of its profits as dividends when it was yielding 3.87%.
That is not the case today. Bank of America is paying out $1.80 in dividends against approximately $5.10 in expected net profits, which means that the bank is paying out almost $8 billion in dividends to shareholders out of $22 billion in profits that it earns. This means that there is approximately $14 billion in profits that are being retained for stock buybacks, bolstering of the balance sheet, and growth initiatives (once it is out of the penalty box with the Fed).
Buffett has often described his favorite businesses as those that contain a license to print money embedded somewhere in its business model. Though he has never praised a bank by name for doing this, probably because it is unseemly, predatory, and would invite regulatory scrutiny, he has gotten rich off of customers that earn easy money via overdraft fees. Right there on page 55 of Wells Fargo’s annual report is the item entry that Wells Fargo collected $4.7 billion in fees from overdraft charges.
That is always the major caveat about seeing these major banks enter low-income areas and profess their desire to conduct business with “underserved communities” or whatever the jargon of the day is. There is a real self-interest from the major financial institutions that do this. None of Warren Buffett’s major bank investments charge less than $35 for an overdraft. Meanwhile, the credit union average is $24.63 and there are some credit unions out there with overdrafts as low as $15. I have never heard anyone mention at the Berkshire Hathaway annual meeting what added value Warren Buffett thought his bank investments were providing by charging 133% more for overdraft fees than what the cheapest credit unions charge.
The best response he could give is that no one is required to spend more in their account than they have in it, that the bank deserves compensation for fronting the money as a short-term loan, and besides, a high overdraft fee should act as a deterrent against overspending in the spirit that an excise tax acts as a deterrent against smoking.
Otherwise, Wells Fargo continues to chug along as it actually made loans of $170 billion in residential mortgages last year (while $230 billion in applications came in). Essentially, Wells Fargo’s loan portfolio continues to grow at a 6-8% clip. I suspect that this is why it makes so much money over the long haul–in some states, particularly the West, it has a secured interest against 1 in 10 homes in the county. The brokerage and trading fees, the overdraft fees, the card fees, are all profit augments to this core profit engine.
Oftentimes, in a small county, the bank is not in a position to make a large mortgage in the $1 million more range. Some credit unions only lend $30 million in mortgages throughout the entire year! Often, Wells Fargo, or one of the other major banks, is brought in to provide the actual cash that becomes part of the mortgage for the nicest home in the city. Of course, Wells Fargo and other banks insist on collateral, and they can collect 5-6% on some of these jumbo-sized mortgages that are off-limits for all but the largest banks.
Speaking of size, the cost of compliance with federal banking regulations has completely changed over the past twenty years. For a small bank, the costs of regulatory compliance in 1993 would cost less than 1% of profits. Today, that cost is nearly 13% for banks with market caps below $100 million.
Want to make a mortgage loan? Pay for attorneys to ensure compliance not just with the Fair Housing Act, but also perform a disparate impact analysis consistent with the Supreme Court’s framework in recent holdings concerning the Fair Housing Act. Make sure that the loans comply with the Equal Credit Opportunity Act, which no longer can be taken care of by using standardized forms, but instead, must comply with each and every one of Regulation B’s prohibitions that relate to “every aspect of an applicant’s dealings with a creditor regarding an application for credit or an existing extension of credit.”
These are real agency costs that are harder for smaller institutions to absorb, and I expect that more bank acquisitions will be in the offing. For the time being, Wells Fargo entered into a Consent Order agreement with the FRB that would ban it from most M&A activities, but within the next year or so, some bolt-on acquisitions will likely occur. The extreme regulatory environment encourages tie-ups like BB&T Bank and Suntrust, and I expect that Bank of America, JP Morgan, and Wells Fargo will be the primary beneficiaries.
In the short term, Wells Fargo did not rise as well as its bank peer stocks on Friday because it candidly acknowledged that interest rates may be slower to rise and its net income attributable to a rise in rates may not rise as quickly as previously predicted. That prediction is well-taken given that President Trump is trying to fill the Fed with individuals that favor lowering, rather than raising, interest rates.
My view is that Wells Fargo is doing just fine bringing in $20 billion in net profits in the current interest rate environment, and much of its growth comes from the growth of loans in its portfolio as well as fee and advisory income anyway, and so the delayed tailwind of interest rate hikes is something that will impede its ability to deliver double-digit returns to shareholders.
A few years ago, I made a lot of money with Bank of America because it was being highly criticized in the media even though its profits were strong, its valuation was low, and its dividends were a low percentage of profits. The underlying assets of the bank were dramatically superior to public perception, and the low price facilitated subsequent wealth-building.
Wells Fargo is not quite as cheap as Bank of America was even just a few years ago, but it is still positioned for market-beating returns and is favorably valued compared to the typical S&P 500 component. A payout ratio that remains in the 30%-40% range, a 3.87% starting dividend yield, 6-7% core earnings per share growth, 1-2% earnings per share growth from stock buybacks, and a hint of P/E ratio expansion suggest that this stock will deliver returns between 10% and 14% over the coming 5-10 years.
Unlike nearly every other stock I have purchased in the past year or so, it is especially well-positioned against a recession because it is currently trading at a discount to its fair value. If a recession were to come, it would go from “undervalued” to “really undervalued” which involves less loss than the companies that must burn off overvaluation. With Wells Fargo’s current earnings power intact, a 50% paper loss would mean that the stock would be trading at 4.5x earnings, which I regard as a lower probability than the notion that a business like Visa might someday trade at 20x earnings again.
Wells Fargo has a high starting dividend, high single-digit growth, and is retaining billions in profits. It is one of the few crown jewel assets that can be purchased right now at a discount, let alone without overpaying. "