Better Buy: Wells Fargo vs. Citigroup

These days, bank stocks are out of favor -- and that's putting it mildly. 

With the market at near all-time highs, many growth companies, especially in the tech sector, are priced at extremely high valuations. Yet big U.S. banks are priced around 10 times earnings, an astonishing divergence from other stocks. In fact, the sector's extremely low valuations have lured the likes of Warren Buffett to scoop up bank stocks over the last few years.

Two of the country's biggest banks with the cheapest valuations are Citigroup (C 1.35%) and Wells Fargo (WFC 1.13%). Not only have these stocks' valuations been hit by concerns over the flattening yield curve, but they're also priced at discounts even relative to their big bank brethren.

Let's dig in to see which one is the best buy today.

Image source: Getty Images.

Business model

While Citigroup and Wells Fargo are often grouped together, they have pretty different business models. Citigroup is very focused on credit cards in its consumer division and has significant investment banking and sales and trading operations for institutions. Citi is also the most "international" of the large U.S. banks, with significant operations in both Latin America and Asia.

Wells Fargo, meanwhile, is almost entirely concentrated in more straightforward consumer lending and wealth management within the U.S. Its loans consist of traditional mortgages, auto loans, and business loans, along with straightforward fee-based services such as wealth management and business wholesale banking.

Because Citi's revenue has exposure to more volatile geographies and perceived higher-risk businesses like credit cards, its earnings are thought to be a bit more volatile than those of the other big U.S. banks. Hence it has generally earned lower returns on capital than leading U.S.-oriented big banks and has historically been priced lower, though its metrics there are improving.

Wells Fargo's current low valuation is for an entirely different reason. Traditionally, Wells had actually been valued higher than other large U.S. banks due to its excellent underwriting in prime loans and ability to cross-sell products to qualified customers. However, Wells has been plagued by scandals over the past few years. In September 2016, it was revealed that Wells employees were opening fake accounts for customers. Since then, several other customer abuse scandals have been discovered in just about every other consumer segment of the bank.

These incidents have caused Wells to lose two CEOs in the past three years and even led the Federal Reserve to impose an asset cap on the bank, essentially preventing the company from growing until U.S. regulators are satisfied that it has a handle on internal risk. Wells has thus had to spend heavily on compliance, while not growing -- not exactly a recipe for success.

Second-quarter operating metrics

Despite Wells' caps on growth, its operating metrics are still better than Citigroup's -- though to its credit, Citigroup's numbers have been improving at a greater clip than Wells' in recent years. 

Data source: Wells Fargo and Citigroup second-quarter earnings releases.

Yet on most metrics, Wells Fargo still seems like the higher-quality bank. Setting aside the low revenue growth, it has higher returns on its assets and tangible equity. That generally means that it's in more favorable businesses with higher interest spreads.

However, Citigroup does have a better efficiency ratio, meaning its non-interest expenses divided by revenue. That may be a feature of its business mix, which could have lower net interest margins combined with lower non-interest costs. It could also mean that Wells has had to bear extra costs due to the scandals of the past few years.

Interestingly, both companies have been able to generate outsized earnings growth, despite tepid revenue growth. This has been due to digital transformation efforts, which have allowed all the big banks to generate huge cost savings from digitizing many back-office and routine tasks, along with branch closures. In addition, ample share repurchases have enabled Wells and Citigroup to lower their share counts by a whopping 9% and 10%, respectively, in just the past year.

Valuation

As mentioned earlier, both banks are also screamingly cheap by just about any metric you can think of:

Data source: Wells Fargo and Citigroup earnings releases, Yahoo! Finance.

Both companies sport low price-to-earnings and price-to-book ratios relative to their earnings growth, and each has an ample Tier 1 Capital cushion. Still, it does appear Citigroup is generally cheaper across the board.

Which to choose?

By these metrics, I think both companies are solid buys for today's value investor -- your choice likely comes down to which business model you prefer. In the near-to-medium term, I think Citibank is probably the better buy given its dirt cheap valuation and improvements being made since the financial crisis.

However, I think once the Federal Reserve lifts Wells Fargo's asset cap, Wells may be the better buy for the long-term, given its higher-return profile and traditionally higher valuation. Of course, it's uncertain when that will occur.

Initially, Wells said it thought the cap would be lifted in the first half of this year. However, this past winter recently departed ex-CEO Tim Sloan moved the lift date to the end of 2019 just before he resigned. Wells is also without a permanent CEO, so I think the stock may languish for a bit until it has a new leader and the "all clear" from the Fed. Still, for the (very) patient investor, I think Wells may be the choice.