Wells Fargo (WFC 0.89%) has certainly been on a bumpy ride over the last few years. It has had to deal with the fallout from its phony-accounts scandal, its many leadership changes, and its slumping profitability due to the coronavirus pandemic. All of these struggles may lead some to believe that the stock could be risky, which is certainly a fair question given everything that has happened. I, however, do not see the stock to be that risky in the long term, especially at the current levels the bank is trading at. Here's why.
Safety of the bank
You can examine risk at Wells Fargo from a safety standpoint, and whether the bank can return to its former profitability levels and raise its stock price.
From a capital and credit quality perspective, the bank presents little risk of failing or not having adequate capital to deal with potential loan losses. The coronavirus pandemic gave the banking system its first real test since the Great Recession, shuttering parts of the economy for months on end, with rising unemployment numbers and falling gross domestic product (GDP).
Image source: Wells Fargo.
While there has been much-needed intervention from the Federal Reserve and the federal government through things like stimulus, Wells Fargo has maintained solid credit quality. Net charge-offs (debt unlikely to be recovered and a good representation of actual loan losses) in the fourth quarter of 2020 were just 0.26% of total average loans, down from net charge-off levels in the fourth quarter of 2019. The bank has also built up nearly $20 billion in reserves for loan losses that largely haven't materialized yet. Wells Fargo also recently had $31 billion in excess capital above its minimum capital levels that regulators require for the bank.
Additionally, the bank performed well in the Fed's latest round of stress testing. The Fed put Wells Fargo's balance sheet through a hypothetical economic scenario where unemployment would rise to 12.5% by the end of 2021, nearly double what it is now, and GDP would decline by about 3% between the third quarter of 2020 and the end of 2021.
This scenario seems like a long shot, but if it did happen, the Fed estimates the bank would experience close to $60 billion in loan losses over the next two years, or the equivalent of 6.5% of its total loan portfolio. Remember, the bank only had a net charge-off rate of 0.26% in the fourth quarter of 2020, and even if it had to absorb the $60 billion in losses, the bank would still have sufficient capital, the Fed's modeling found.
Returning to its former self
After seeing Wells Fargo's stock price plummet in 2020, investors might be wondering about another risk -- whether the bank can return to its former glory. After all, the bank only generated a $3.3 billion profit in 2020, down 83% from 2019, while trimming its dividend by 80%.
Although these numbers are certainly concerning, I am fairly optimistic that the bank will be able to increase its earnings back to a reasonable level and grow its stock price. Wells Fargo struggled in 2020 after the Fed dropped its benchmark lending rate to practically zero, significantly cutting the bank's profit margin on many existing loans. That, coupled with higher credit costs, led to the brutal year for the bank, which is primarily a commercial lender.
The bank is also still operating under a $1.95 trillion asset cap the Fed placed it under after its phony accounts scandal came to light in 2016, in which the bank opened millions of unauthorized accounts on behalf of its customers. Until the asset cap is removed, the bank will not be able to significantly grow its balance sheet to offset smaller loan margins. The asset cap also prevented the bank from reaping any benefits from the Paycheck Protection Program.
The good news is that even though the asset cap has now been in place for about three years, it does seem like the worst from the phony-accounts scandal is behind the bank now.
Furthermore, the bank's CEO Charlie Scharf has been making moves to improve profitability by pledging to ramp up the bank's investment banking division and by cutting billions of dollars from its annual expense structure. Additionally, the only reason the bank had to cut its dividend last year was due to restrictions put in place by the Fed. The bank has plenty of excess capital, so it should be able to increase its dividend back to a more normal level once the restrictions are removed, potentially later this year. The bank will also be able to resume repurchasing shares this year to boost earnings as well.
Not too risky at these levels
Recently trading around $33.20, shares of Wells Fargo are valued slightly above tangible book value, which is toward the lower end of valuations in the bank sector right now. It appears that the market has already priced in the impact of the asset cap, the pandemic, and potential revenues and earnings difficulties in the near term. So the stock doesn't look risky at these current levels, and it has an opportunity to return to its former levels of more than $50 or $60 per share long term.
