Wells Fargo (NYSE:WFC) has underperformed the financial sector for years, and for good reasons. From its numerous scandals to the asset-cap penalty that prevents the bank from growing, Wells Fargo was hurting before the pandemic.

And as the only big bank without a large investment-banking operation to help offset the effects of the COVID-19 pandemic, Wells Fargo was hit harder than most in 2020. But on this week's installment of Industry Focus: Financials, Fool.com contributor Matt Frankel, CFP, tells host Jason Moser why he thinks this could be a great value investment as we head into the New Year.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Jan. 4, 2021.

Jason Moser: It's Monday, Jan. 4, I'm your host Jason Moser. We're kicking off a theme week here on Industry Focus this year, the first week of 2021, it's our top stocks for 2021. Our guests throughout the week will be offering up a stock they like for the coming year in the show's respective market or industry, and we'll dig into why. Kicking it off for our financial show this week, Certified Financial Planner, it's Mr. Matt Frankel. Matt, happy new year.

Matthew Frankel: Hi, Jason, how are you?

Moser: I'm doing well, how about yourself?

Frankel: Pretty good, it was a busy but nice new year. [laughs] Hopefully you got a chance to relax, [laughs] because I feel like I did nothing but run after kids, but we had a great time and they had a fantastic time.

Moser: Well, that's holidays with the family. There is never really a dull moment it feels like, but that is the idea. I was thinking about this as our older daughter just turned 16 yesterday, and it struck me that, wow, you got two years basically and she's off to college, so it flies right by, and it makes you appreciate these times together a little bit more. Granted, we've had a lot of time together [laughs] over the past year, but hopefully we're turning a corner there and 2021 will be a little bit better. We will wait and see there. But, Matt, this week on Industry Focus is going to be a really fun one, because we're giving all of our guests the opportunity to jump out there in front of our listeners and throw them their top stock idea for 2021, and we thought this would just be a neat way to kick off the year, to get some investable ideas out there for our listeners. The financial industry, obviously a very wide reaching industry. We talk about everything from banks, to insurance, to real estate here on the show. We talk about taxes and financial planning as well. We were making a joke earlier before taping though, given the way technology is shaping up, it's kind of nice. We're able to throw some SaaS businesses in here too now, aren't we? [laughs]

Frankel: Yeah. The fintech industry has really opened up a whole new avenue for us.

Moser: Yeah, it has. It's been a lot of fun and certainly it's something we talked about a lot in 2020. I want to go ahead though and jump into your top stock for 2021 here on today's episode, because when you picked the stock I had a couple of reactions. One, a little bit of a contrarian play, and it also runs a little bit counter to what I know has been one of your top stocks in this industry over the past couple of years, we've talked a lot about on the show, but go ahead and, for the big reveal here, what is your top stock for financials in 2021?

Frankel: Well, I think that 2021 is going to be a year of value stocks. I don't think it's going to be a great year for growth stocks. They had their year in 2020. Let's be honest.

Moser: They had a good year, that's for sure.

Frankel: Value stocks are generally the reopening stocks. They're the older businesses, the mature businesses, things like that, so I'm going with a beaten down bank stock, and I've been hesitant to pull the trigger on this one for a few years. I'm finally ready to say Wells Fargo is the one to go with.

Moser: Wow, Wells Fargo, one that we have not been too terribly easy on here over the past several years. They have really deserved the scrutiny that not only we, but really the investing population in general --

Frankel: Yeah, and I've been right there with your saying that. [laughs]

Moser: Yeah. Well, listen, they earned it. But we talk about this often when we talk about companies that are a little bit on the down and out. It's important to be able to recognize if the problems they're having are fixable and it seems like in this case you feel like they are fixable. What do you feel the catalysts are here for Wells Fargo here for this coming year and beyond?

Frankel: Well, there's a bunch of them, but before I do that, let me just tee this up by saying how beaten down they are and not just because of COVID. They dropped about 45% in 2020. That was mostly COVID related. They're almost purely a consumer bank. Consumer banking did horribly. They all had to set aside billions of dollars and unlike a lot of the other big ones, Wells Fargo didn't have a giant investment banking unit to really help offset some of the losses. Before that, we had the fake accounts scandal, there was the mortgage insurance scandal, there was the auto-insurance scandal, which I was a victim of. [laughs] I got charged for bogus auto-insurance at one point when I had my Camaro. That was financed under Wells Fargo. Because of all those issues, they have underperformed the financial sector by 94% over the past five years.

Moser: Wow.

Frankel: It has been a fantastic environment for banks. Most banks have done great. If you look at a five-year chart of a Bank of America (NYSE:BAC) or a JPMorgan Chase, they've done great over the past five years, with the exception of 2020. Wells Fargo really hasn't, because even before this, they were in the doghouse. I think that could all change this year, and I already alluded to the first reason why. It's because they're primarily focused on commercial banking. Meaning, they're pretty much a savings and loan. They have a small investment banking operation, but I mean, their trading revenue was less than 2% of the total this last quarter. It's not much. But the focus on commercial banking, while that was their biggest handicap in 2020, could be their biggest asset in 2021 as things start to reopen.

Moser: You're thinking, now, is part of this the idea that Wells is serving as a conduit for the payroll protection program and they're able to not only help get that money out to their commercial partners that need it the most, but then also, you're going to see the benefit from the reopening in the end, the actual businesses start picking back up as well.

Frankel: Yeah, I mean, Wells Fargo built-up their reserves by $3.1 billion in the first quarter, 8.4 billion in the second quarter. If that doesn't turn into actual losses, this is just reserves, this isn't money they've actually lost. If that doesn't turn into actual losses, because the economy is reopening, then those reserves can get released, they won't have to set aside a ton more money. Their default rate is not going to tick up. It really doesn't look too bad right now, their default rates or the charge-off rate is at 0.29%, which is actually really low for a bank right now. I mean, the nonaccrual loans, meaning loans that aren't being paid on right now, are at $2.5 billion, which sounds like a lot but, I mean, they set aside over $11 billion in the first few quarters.

Moser: Yeah, not in the context of the reserves. In the context of reserves, it sounds OK.

Frankel: Right. The point is their business got hit harder than most, but as things start to normalize and they don't really need all these billions of dollars in reserves, because that's the reason they weren't profitable throughout a lot of 2020. It wasn't because they were actually losing money, it's because they were setting aside these reserves and that counts as negative earnings.

Moser: We saw JPMorgan. I mean, another great example, a little bit of a different operator there, but JPMorgan, I think at some point recently, I think it was the October quarter, they have reported somewhere in the neighborhood of $30 billion in reserves they put aside. Jamie Dimon, on the call, was talking about a tale of two-halves of 2021. Whatever charge-offs they see, they expect that the peak here in the first half, then to what you've been talking about here, you really start to see those reserves being released. That trickles down to the bottom line and can make a big difference. Now, the other thing that we're talking about too and I'd love to get your take on this is buybacks. Share buybacks and dividends are a big part of the thesis when you invest in banks typically, aren't they?

Frankel: Right. All banks had to suspend their buybacks in 2020, as the pandemic worsened. That was the Federal Reserve that said, "Okay, pump the brakes on buybacks for the time being." They just gave banks the go-ahead to resume buybacks starting in the first quarter if their capital levels allow it. Wells Fargo has $25 billion in excess capital right now because they're not allowed to do anything with it. They're also limited in how much dividends they could pay this year. If you remember, Wells Fargo was the only one of the big four that was really forced to slash its dividend, and it ended up cutting its payout by 80%. It's got all this excess capital sitting on the sidelines, that $25 billion is probably going to grow by the next time we hear about it, just because they're profitable right now. Once they could start buybacks, there's reason to believe they're going to do it aggressively. In 2019, their buyback authorization was $23 billion. To put that in context, their market cap is $125 billion right now. They have the ability to get very aggressive with buybacks, provided that the Federal Reserve approves their plan. But the Federal Reserve already cleared Wells Fargo to resume buybacks. The bank is profitable, so it will be justified. The Federal Reserve should allow it, there's no real reason to think it won't. That could be a huge catalyst, because the stock is cheap right now, it's trading for a discount to book value. You're essentially buying $1 in Wells Fargo's assets for about $0.90 right now. The bank likes to be aggressive when their stock is perceived to be cheap, especially. I think this could be a huge catalyst going forward.

Moser: Yeah, that makes a lot of sense. When you look at Wells Fargo and you compare that to something like Bank of America, for example. Bank of America, essentially a company twice the size of Wells Fargo, which is amazing to think about. But I think that's a testament to, one, how far Wells Fargo has fallen, but also, as I was noting at the beginning of the show, this pick was a little bit counter to the other banks that you've really been pounding the table on here in the past couple of years. You've been a real fan of Bank of America for a while. I got to admit, there was part of me that thought you might be going Bank of America, but I liked the idea here of the value play, finding a big operator that is down and out with some solvable problems. Certainly, trading at a discount if they are able to solve those problems. It does sound like there are plenty of catalysts. Let's talk a little bit about Wells' relationship with Fed, because they've been dealing obviously with the capital and buybacks, the capital and dividends. There was a Fed penalty involved two-year with this business, right?

Frankel: Right. Well, first of all, Wells Fargo is still Wells Fargo. It's important to point that out. In South Carolina, Wells Fargo is the biggest bank in this area. I'm a Wells Fargo customer, pretty much everyone I know is a Wells Fargo customer. A lot of people that I know were victims of one of their various scandals because there were so many of them. But do you know how many people I know that have switched away from Wells Fargo?

Moser: I got to believe it's probably none because it's too much pain to do it.

Frankel: Zero. It is a pain to switch banks.

Moser: [laughs] Yeah, it really is, there's something to that.

Frankel: They're still Wells Fargo, this is still the big operation. But you mentioned their Fed penalty, this will be three years in February since the Fed put this penalty on Wells Fargo. It's unprecedented, they said that they're not allowed to grow their assets, the bank is not allowed to grow. It's arguably been the best growth environment for banks in 30 years after the tax cuts and the strong economy, there's tons of demand for loans right now just because interest rates are low. It's been a great environment for banks to grow, which is why the rest of the banking sectors performed well. But in Wells Fargo's case, it's not allowed to grow. Everyone pretty much thought that the penalty would've been lifted by now. The condition was very vague, it was when Wells Fargo made substantial changes to its corporate culture, and enough to satisfy regulators, which is a very vague condition.

Moser: It really is. I wonder how they measure that stuff. Certainly, you can't just say, "Well, we're going to go by what your Glassdoor rating is and then [laughs] going to go from there."

Frankel: First, they got rid of the CEO who had presided over the bank during all the scandals, and replaced him with someone else internally. The Fed said, "No, that's not good enough." Now that they finally have a new CEO, Charlie Scharf, pretty much a brand-new management team, they've overhauled the Board, they've made big changes to the incentive structures that were really the root cause of the problem in the first place. It's tough for me to make the argument that they haven't made enough changes. I mean, what does the Fed want them to do? Change their name? Other than what they've done, I really can't think of how they would overhaul their business anymore, other than actually selling themselves to a competitor or something like that. I think there's a high probability that that gets removed in 2021.

Moser: How do you feel like management is kicking around this idea in the boardroom, the current interest rate environment? We talked about this, it seems like forever that interest rates only can go up and yet they continue to go down. Then, I know that you and I both took advantage of refinancing in 2020.

Frankel: Yes, the consumer, I love it.

Moser: Yeah, it's just a wonderful environment as a consumer. But obviously, banks would love to see those interest rates start coming back up because that will make it a little bit easier on that bottom line for them. What do you think the chances are that we actually see that rate environment firm up a little bit here in 2021?

Frankel: Well, that's an interesting point, because it really has an effect. When I say Wells Fargo is down 45% this year, it's not just the COVID loss reserves and stuff like that, interest rates are a big part of that. In the third quarter, their net interest income was down 20% year-over-year. These low interest rates are killing their profits. I think the market is really underestimating the chances of interest rates rising in 2021. I'm not talking about the Federal funds rate. The Fed has pretty much said that they're going to keep interest rates low for a while. They want to see a lot of inflation before they even think about raising rates, but it's important for investors to remember that things like mortgage rates and auto loan interest rates, they're not dependent on the Federal funds rate. You can have mortgage rates rise without the Federal funds rate rising. They tend to move in the same direction over time, but one is not tied to the other. I think, as consumer demand starts picking up, as you see, the unemployment rates start to normalize, one, you're going to start to see inflation. They think it's going to be really tough to get to that Fed's 2% or 2.5% inflation target. I really don't think it's going to be that tough. All the stimulus they are injecting into the economy, they were talking about doing another round of stimulus after the Biden administration takes over. Consumers want to get out there and spend. Pretty much everybody I've talked to, no matter where they are in the country, are booking vacations for 2021. These are people who don't like to go anywhere normally. People are trying to get out and spend money. I think the market is really underestimating the possibility that we see a significant rise in consumer interest rates in 2021.

Moser: Yeah. I think there's something to that. I mean, I agree with you. I think a lot of people are ready to get out there and spend. Listen, we heard about it all leading up into the close of 2020, everybody ready to turn the page to get into 2021. You got to recognize the fact that, just because it's 2021, everything is still the way it was a few days back. It's going to be a little bit of a slow change here, but once we get there, and it feels like we are at the cusp, that really could be something that lights up the economy. We definitely have already planned a vacation for June as well.

Frankel: There you go.

Moser: I see where you're coming from. Let's fast forward six months from now. We're following this Wells Fargo story along. What are the risks to this idea here? What are the things that you're keeping your eye on that will provide signals as to whether they're doing the right things or still not quite there yet?

Frankel: It's important, first of all, to point out the pandemic is still a fluid situation. That's the No. 1 risk here. When I say a great stock for 2021, I still think Wells Fargo is going to be a great start for the long-term regardless. But as far as 2021, the pandemic is still a big risk. With Wells Fargo and pretty much every other reopening stock, there's still a lot of uncertainty priced in when it comes to the timetable. You and I are relatively healthy adults. It could be March before we can get a vaccine, it could be September, we don't know. Then, once vaccines are widely available, when will the actual pandemic die down to the point where we can move about the country freely? We don't know. There's a lot of uncertainty here. If it turns out to be March, that's going to be a fantastic catalyst for Wells Fargo. If it turns out to be September, not so much. But I'm thinking it's going to be somewhere in the middle of there. That's one big risk. Unemployment risk is a big one, if people actually end up having trouble paying their bills. I mentioned that their default rate hasn't really ticked up much, but that's the third quarter, that was when most of the stimulus was still working its way through the system when case numbers weren't spiking out of control. There could be some long tailored effects in the fourth quarter and first quarter. They could eat up a lot of their reserves I was talking about, so that's a potential hole in the thesis. There are some things that can go wrong here. There's no such thing as a no-brainer investing. That's especially true here. I think Wells Fargo in the $20s, like it is right now, is a pretty big no-brainer. Then there's always the overall risk in the banking industry of customers leaving not for other banks or because of Wells Fargo scandals, but leaving for the online competitors that we're seeing pop up. Pretty much everybody is starting a bank now. Square is starting a bank. There's a bunch of options, if you want a higher interest rate, there's options. They're doing a better job of replicating a checking account online than they were doing just a few years ago. There have been high yield savings accounts, but checking accounts have been tough to replicate. That's a big risk just in the industry in general, that's worth keeping an eye on.

Moser: It does feel like, to me, we've talked about this before, the open-mindedness of younger generations to look at some of these new fangled tech companies that are essentially partnering up with financial institutions to be able to offer financial services. I think maybe Lemonade, a good example there of an insurance company. They're putting that insurance risk on the reinsurance market, and they are focused more on utilizing data to provide a really good service for an upcoming generation of consumers that are going to need insurance. It always makes me wonder in regard to Wells Fargo, for the folks that are already in there, they are in there. Attracting new account holders, I don't know how easy that is for them. I guess the one shining light on their business model is that dominant presence in the mortgage market. A lot of times, there's homebuyers, Wells Fargo is the one that ends up servicing that mortgage in many cases.

Frankel: They're my mortgage servicer. [laughs]

Moser: Then that obviously, it's a big deal, because they can take that and that they can couple banking services and develop the relationship from there. But yeah, I guess I always wonder just in regard to the younger generations of consumers, how many are really interested in going out there to open up an account with something like Wells Fargo when there are all of these new more tech driven, customer centric options out there.

Frankel: I loved that they are maintaining their dominant share of mortgage servicing. I'll tell you why. I refinanced my mortgage with better.com. I don't know if you've heard of them, they are one of the online disruptors in the mortgage space. I highly recommend it by the way, I wrote them a very nice piece on our ad sense site about my experience.

Moser: Nice.

Frankel: It was just a fantastic experience. But the point is, I used one of these online disruptors to get away from banks like Wells Fargo and Bank of America and all that. What happened three days later, Wells Fargo bought my mortgage from them. [laughs] I can't get away from Wells Fargo. Even if people are going through these online disruptors, they are doing a good job of forcing people to have Wells Fargo accounts essentially. I find it really convenient to have my checking account, my mortgage, or my auto loan all at one place, I really do.

Moser: I agree with you there. Whenever you have different accounts in different financial institutions, then you have to link up all those accounts and figure out ways to pay. It becomes a little bit more convoluted than it needs to be, and that certainly goes back to just switching accounts; it's a lot more work than it feels like it's worth. But yeah, I think Wells Fargo, through the years, has done a very good job. I feel like Mastercard and Visa have done a similar job in the face of an industry that is changing so quickly, thanks to technology. They figured out ways, even though they may have been a little bit slow to change, they figured out ways to participate in that newly evolved value chain. I mean, whether it's Visa or MasterCard, partnerships with companies like Square and PayPal, Wells Fargo, and the same kind of thing, you're seeing these financial institutions partnering up with these tech companies that are bringing new customer-centric approaches to the market, and then still being a part of their value chain, and that really doesn't mean the business can continue to be successful if they work hard at it.

Frankel: I would like to personally see Wells Fargo get a little more aggressive with pursuing partnerships with some of the fintechs, I think that would do them good. Like you said, a lot of companies don't want to be banks themselves, but are partnering with the big banks. I know JPMorgan has a bunch of partnerships in that respect, and so does Bank of America, for that matter. Wells Fargo really hasn't had that level of success. Bank of America, when I've talked about them before, you mentioned that. I still like Bank of America. I mean, they're my biggest bank stock holding, but they've done a much better job than Wells Fargo of embracing technology.

Moser: As a Bank of America account holder, I can tell you they've done a really good job with that. I'm with Bank of America accounts and it's not because I just love Bank of America, but we've had them forever and they've been just very acceptable. It's been good service and good tech there that makes it very easy to bank with them. I'm glad you mentioned that in regards to the banks aspect of it, because really, I view that ultimately as a competitive advantage. I mean, the cost in the barriers that come with actually being a bank. There are a lot of rules and regulations, a lot of capital ratios you have to adhere to. That is not an easy life being a bank, and so that to me does feel like a competitive advantage to a degree at least.

Frankel: Absolutely. You mentioned costs there. That's another thing Wells Fargo needs to do a lot better, and I think they will with their new leadership. We did mention earlier that they have the worst efficiency ratio of any of the big banks. Efficiency ratio, if you're not familiar, is essentially how much banks are paying to generate their revenue. An efficiency ratio of 50% means they're spending $0.50 for every $1 of revenue they are generating. Most of the big banks have been in the $50s over the past couple of years. Wells Fargo was $65 in 2018 and 68 in 2019.

Moser: Ouch.

Frankel: They have pretty high efficiency ratios. Their priority for the past decade, as misguided as it was, was to cross-sell as many products to their customers as possible to make their sales goals. All the other banks prioritized embracing technology and reducing expenses. The other banks won. But Charlie Scharf, he's going to cut $10 billion of expenses from Wells Fargo, is his big priority. It's so nice to see them shift to that mindset away from just straight sales goals, because there's two ways to make money in business. You can increase your sales or you could decrease your expenses. They've really neglected the latter of those two and it's nice to see them finally prioritizing it.

Moser: Yeah. Well, it sounds like plenty of opportunity there and I really appreciate you bringing that idea to us. I love it. I think it's a neat contrarian play. I think it's a very reputable firm with some problems here recently. Those problems sound fixable and maybe new leadership is up to the task. Matt, I think that's going to do it for us today, but thanks, as always, for taking the time to jump on and I really appreciate your spotlighting your top stock in the financials industry for 2021. I know our listeners are going to love it.

Frankel: I hope so. I think it's going to surprise a lot of people, Wells Fargo, over the next few years.

Moser: All right. Well, remember, you can always reach out to us on Twitter at @MFIndustryFocus, or drop us an email at industryfocus@fool.com. Let us know what you think about Matt's top stock there for 2021 and Wells Fargo, and hey, listen, if you've got a top stock for 2021, don't be afraid to let us know. Maybe we could even read some of those ideas out on the air next week, Matt, I think that'd be a good idea.

Frankel: Yeah, for sure, and we can each give our take on whatever the ideas are.

Moser: All right. As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Thanks, as always, to Tim Sparks for putting the show together for us. For Matt Frankel, I'm Jason Moser, thanks for listening. We will see you next week.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.