Generally speaking, I love investing in companies that have issues but still have a bright future. In fact, some of my best-performing investments, such as Square, Bank of America, Apple, and American Express were made shortly after something went wrong. As one example, I bought American Express shortly after Costco dropped the credit card giant as its co-branding partner.
So it may seem like scandal-plagued banking giant Wells Fargo (WFC 2.74%) might be right up my alley. Because of the bank's infamous fake-accounts scandal and other issues, Wells Fargo has significantly underperformed its peers and may look attractive to bargain-seeking investors.
Image Source: Wells Fargo.
First, the good
In the wake of the scandal, Wells Fargo's leadership changed. And to give credit where it's due, now-CEO Tim Sloan is doing an excellent job of owning the bank's mistakes and trying to rebuild the public's trust. In fact, the bank's most recent annual report was entitled "rebuilding trust" and featured extensive discussions from board Chair Elizabeth Duke and CEO Sloan about the steps the bank has taken to fix its corporate culture, such as eliminating sales goals for retail bankers and incentivizing customer satisfaction instead.
Also, Wells Fargo still is a rather profitable bank with good risk management. The bank's first-quarter return on equity of 12.37% and return on assets of 1.26% were well ahead of the 10% and 1% respective industry benchmarks, and net charge-offs continue to fall and are below the peer group average.
Finally, Wells Fargo stands to benefit from tax reform and rising interest rates, two positive catalysts that should add to the profits of the entire banking industry.
Too many unknowns
Having said that, there are simply too many unanswered questions at this point. The aftereffects of the fake accounts scandal and other bad behavior have been apparent in the bank's results for the past several quarters. While most peers are seeing strong deposit and loan growth, Wells Fargo's are declining. And there's no way to answer the questions of "How long will this last?" and "How much further will Wells Fargo's business decline?"
In addition, the development that I find to be the scariest from an investor's perspective is the unprecedented Federal Reserve ("the Fed") penalty levied against the bank in February. If you aren't familiar, the Fed essentially told Wells Fargo that it's not allowed to grow beyond its asset size as of the end of 2017 until the agency is satisfied that "substantial improvements" have been made.
For one thing, this leaves even more unanswered questions -- specifically, what constitutes "substantial improvements?" How often will the Fed review Wells Fargo's progress? When the bank has been deemed to have made progress, will it be allowed to grow unimpeded or will there still be some lighter restrictions placed on the bank?
In addition, the current business environment is very conducive for growth in the banking business. It's tough to justify investing in the one bank that isn't allowed to take advantage.
Not right now
Berkshire Hathaway CEO Warren Buffett recently predicted that Wells Fargo will outperform the rest of the big U.S. banks over the next 10 years. While I generally agree with most of what Buffett says, this is an exception. I just can't justify investing in a bank that isn't allowed to grow and has developed a bad reputation with consumers -- especially while we're arguably in the best environment for banking growth in recent history.
The fact that Wells Fargo actually trades at a higher price-to-book multiple than Bank of America and several other solid banks leads me to believe that investors who want banking exposure are better off looking elsewhere.
