Investing in banks has normally brought me consistently great returns because the business model of a bank is, at it's core, very simple, and the services that they offer will always be in demand. With the S&P 500 up over 140% in the past five years, however, it's getting harder and harder to find undervalued stocks worth buying and holding for the long-term.
In spite of the rise in the market, Wells Fargo (NYSE:WFC) remains the one bank that has perfected its core business of banking and remains an incredible investment regardless of valuation.
Best in breed
On the surface, Wells Fargo may not seem like the best bet of the big banks from a value perspective. With a P/E ratio of over 12 and a P/B ratio of about 1.7, Wells Fargo isn't especially exciting. However, Patrick Morris at The Motley Fool does an excellent job of pointing out how great Wells Fargo is compared to its peers.
Morris highlights several important valuation metrics for banks. In the article, he looks at Wells Fargo's return on average assets (the profitability of a company's assets), return on equity (how much profit a company generates with its shareholders' money), and net interest margin (how well a company's investments perform when compared to its debts). When compared to its peers, Wells Fargo is performing at a much higher level. But if you are looking for more convincing than Mr. Morris provided, let me take a crack at it.
Banks behaving badly
The financial crisis that occurred in 2008 hit the banking sector hardest of all, with several large banks failing and other large banks barely surviving with the help of government bailouts. This crisis, in case you had forgotten, was a direct result of the reckless behavior of many of these banks to begin with. But not all of the banks were behaving badly. So how can we tell the good from the bad? The "bad banks" responsible for the crisis had to pull out all the stops to avoid bankruptcy, which often included selling assets. The "good banks" were able to take advantage of the opportunity to actually expand and grow their businesses, much like astute investors were able to take advantage of the low share prices the crisis provided to buy stocks and achieve large financial gains during the recovery.
Getting down and dirty
To see which banks were in the best position to expand their asset holdings, we can compare the current total assets of these banks to the assets they held prior to the crisis.
Total Assets: December 2007
Total Assets: December 2013
|Bank of America||1,716||2,102||23%|
A quick look shows us that three out of the four banks increased their total amount of assets. Wells Fargo stands out, however, by more than doubling in size.
But before we get too excited about these banks buying up assets, we need to know exactly how they are raising the cash for these asset purchases. Let's look at a table that shows how the number of outstanding common shares of these banks (in billions) has changed over the same six-year period.
Share Count: December 2007
Share Count: December 2013
|Bank of America||4,480||11,491||156%|
By comparing share counts, you can see the way Bank of America paid for a large portion of its 22% expansion in total assets: by selling more shares of common stock and diluting its shareholders! Wells Fargo has also raised money by selling shares, but a 58% increase in shares to help fund a 165% increase in assets seems more than reasonable from a shareholder's perspective. JP Morgan has treated shareholders the best of these four banks by only diluting by 9%.
The price of profits
After looking at dilution and asset purchases, it is pretty clear that Wells Fargo and JP Morgan are the two finalists for "best in breed" from this bunch. But, while these two banking giants might seem similar on the surface, their underlying businesses couldn't be more different. In fact, you only need to go as far as their most recent earnings reports to see the difference between the two. JP Morgan reported a first-quarter drop in net earnings of 19%, and the bank's dependence on trading revenue played a large role. On the other hand, Wells Fargo reported a 14% gain in Q1 earnings that included $38 billion in mortgage originations and $7.8 billion in auto loan originations, both of which dwarfed the corresponding numbers at JP Morgan.
It's true that, from a value perspective, it doesn't matter where a company's profits comes from. But from a risk perspective, JP Morgan's reliance on its investment banking profits is a snake in the grass that could spring up and bite its shareholders at any time. Wells Fargo's focus on its mortgage business and its community banking unit provides a far more stable and predictable source of income for shareholders.
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Wayne Duggan is the author of Beating Wall Street with Common Sense and the developer of tradingcommonsense.com. Wayne Duggan owns shares of Bank of America and Wells Fargo. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo and has the following options: short June 2014 $50 calls on Wells Fargo and short June 2014 $48 puts on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.