California lender Wells Fargo (NYSE:WFC) may well have produced record net income in the second quarter, beating the analysts' estimate along the way. A boom in mortgage refinancing, spurred by low interest rates, certainly didn't hurt the largest home lender in the United States. However, investors shouldn't be distracted -- they need to keep their focus on the evolution of the bank's loan book, which is less cheery.

As Goldman Sachs (NYSE:GS) remarked: "Against the credit performance, the primary concern is NPAs [non-performing assets] up 45% on a linked quarter, which is among the highest rates of growth of any bank we cover and much higher than the 15-20% growth seen at most other big banks such as BAC, USB etc ..."

This suggests that greater-than-expected loan losses could pop up to upset earnings through the second half of the year and into 2010. Is that prospect priced into the shares?

How are the shares priced?
At yesterday's closing price of $25.35, Wells Fargo shares are valued at 1.41 times book value per share. While that is at the high end of its peer group (see the table below), the shares haven't traded at such a low multiple in over 15 years. Between March 1994 and the start of the credit crisis in July 2007, Wells' price-to-book value hit a low of 1.90 in December 1994. Since then, the shares have produced an annualized return of 13.6% -- double the market return of 6.8% over the same period.


P/BV Multiple

% Return Since March 9 Market Low

US Bancorp (NYSE:USB)



Wells Fargo



JPMorgan Chase (NYSE:JPM)



PNC Financial (NYSE:PNC)



Bank of America (NYSE:BAC)



Citigroup (NYSE:C)



Source: Capital IQ, a division of Standard & Poor's. Note that some BVs are not updated for the latest earnings releases.

Will they outperform?
Can we expect Wells shares to outperform on an ongoing basis? It's no certainty -- two questions are critical:

  • How will legacy loans perform? (Commercial real estate is an area of particular concern.)
  • What sort of profitability can we expect for banks in a post-bubble environment?

Existing shareholders (I'm including myself) should also consider the likelihood that Wells Fargo will dilute their holdings by issuing more shares during the next 18 months. With all that said, I think it's a decent bet that this lender will outperform the S&P 500 over the next five to 10 years -- though probably not with the same margin it has enjoyed over the last 15.

Respected asset manager GMO is forecasting that "high-quality" U.S. stocks will beat large-cap stocks by more than six percentage points annually over the next seven years! Morgan Housel has identified three high-quality companies that are still cheap.

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Alex Dumortier, CFA has a beneficial interest in Wells Fargo, but not in any of the other companies mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.