Wells Fargo ( WFC -2.74% ) has been a terrible performer for bank investors, and not just during the COVID-19 pandemic. Over the past five years, Wells Fargo has underperformed the Financial Sector SPDR ETF ( XLF -2.23% ) by a staggering 94 percentage points, thanks to its fake-accounts scandal and numerous other issues.
However, there's reason to believe the bank could be one of the best performing stocks in the financial sector in 2021 and for years to come. In this Jan. 4 Fool Live video clip, Fool.com contributor Matt Frankel, CFP, and Industry Focus host Jason Moser discuss why Wells Fargo is Matt's No. 1 financial sector stock for 2021.
Matthew Frankel: It has been a fantastic environment for banks. Most banks have done great. If you look at like a five-year chart of a Bank of America ( BAC -2.28% ) or a JPMorgan Chase ( JPM -2.33% ), 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 to savings and loan. They have a small investment banking operation, but I mean, their trading revenue was less than two percent of the total this last quarter. It's not much. But the focus on consumer or commercial banking, while that was their biggest handicap in 2020, could be their biggest asset in 2021 as things start to reopen.
Jason 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 needed 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 percent 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.
Frankel: So it wasn't that they actually lost money.
Moser: We saw JPMorgan. I mean, another great example, a little bit of a different operator there, but JPMorgan, I think at some point here 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 on down to the bottom line 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 worsen. That was the Federal Reserve said, "OK, 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 dollars 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 is the only one of the big four that was really forced to slash its dividend, and it ended up cutting its payout by 80 percent. 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 a dollar in Wells Fargo's assets for about 90 cents 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.