Wells Fargo and the Incredible Predictability of Deposit Growth

Posted on Posted in Industry-Banks, Investment Ideas & Company Research

“In the end, banking is a very good business unless you do dumb things.” – Warren Buffett

Buffett has been investing in bank stocks since the 1950’s, and I think one of the things he probably likes most about banking is the predictability of deposit growth. As he says, if you don’t do dumb things—if you stick to taking in deposits and lending them out, you’ll mint money.

All the money center banks reported earnings a couple weeks ago. In the process of reviewing their filings, I also spent some time doing some research on the FDIC website and I found a table that the FDIC updates on industry-wide total deposits at all US commercial banks. At the end of 2014, US commercial banks held $10.9 trillion in deposits.

High and Predictable Deposit Growth

Here is the incredible statistic: US commercial bank total deposit growth has grown every single year (not a single down year) since 1948! There have only been 3 years where industry-wide deposits shrank from the year before (1937, 1946, and 1948, and these three years were all very modest declines).

So deposits across the industry have grown for 66 consecutive years.

Even more incredible is the rate of growth in deposits over the past 80 years. Since 1934, deposits held by US commercial banks have grown 7.3% per year. In the past 50 years, they’ve grown at 7.4%. In the past 25 years, they’ve grown at 6.0%. In the past 10 years, they’ve grown at 7.0%.

Bank Deposits

So incredibly, the growth rate doesn’t seem to be slowing down much. I’ve always thought of deposits as something that would grow at maybe just a very slight premium to whatever GDP does over time (2-4%). But at least over the past 80 years, they’ve basically doubled the growth rate of GDP.

I remember Buffett saying something about servings of Coca-Cola sold has risen every single year for 100 years or so. I bet he feels the same about the predictability of deposit growth.

He probably feels the same way about loan growth as well as bank earnings for that matter (which have also risen steadily and unlike airlines, the US banking industry has been profitable in 78 of the past 80 years).

And unlike Coke, since deposit gathering is a commodity type business, the lowest cost business will have the biggest advantage.

Unfortunately for the small community banks which have decreased in number by 2/3rds in the past few decades, the big regionals and the really big guys have these cost advantages. Wells Fargo is currently paying 0.08% (8 basis points) for its $1.2 trillion in deposits. WFC largely funds its asset base with these low cost deposits (the total cost of their funding sources is just 25 basis points), meaning that even in this low yielding environment, it makes a healthy return on assets. Other big money center banks also gather deposits very cheaply, but because deposits make up most of WFC’s liabilities (which also fund a more traditional higher yielding asset base—loans and securities), the bank achieves better returns on capital than the majority of its competitors.

Throughout its history, WFC has always taken market share. I took a look at the 1974 WFC annual report. In 1974, WFC had deposits of $10 billion, today they have $1,202 billion. So in the last 40 years, WFC has a 12.7% deposit CAGR. They’ve grown overall deposit market share from 1.3% in 1974 to 10.9% today:

WFC Deposit Share

(By the way, www.wellsfargohistory.com is one of the best company investor sites: 50 years of annual reports and other info).

So WFC has grown deposit market share, and grown share almost every year—especially in the past 3 decades. Given certain banking regulations and WFC’s size, you could argue that they’ll stop taking share, but as long as they just maintain their share (a pretty good bet given their track record), it seems pretty predictable to rely on steady mid-single digit deposit growth year in and year out. These deposits are the raw material that is used to create loans, which also have grown steadily over the past 80 years (loans have grown at a CAGR of 8.1% since 1934).

If you look at WFC’s ROE, it’s been a consistently profitable bank throughout history:

WFC 40 Year ROE

For the past few decades, the bank has consistently produced better than 1.5% ROA. At 10x leverage, this is about 15% ROE. Recently in this zero interest rate world the ROA has slipped to around 1.3%, so maybe you would say 13% is a better estimate of what shareholders can expect the bank to earn on their capital, but I doubt that a) interest rates remain this low forever and b) ROA doesn’t begin rising once ZIRP comes to an end.

With the deposit numbers and the low-cost moat of WFC, it’s hard to see value per share not compounding at 8-10% (at least) over time through a combination on asset and book value growth, steady returns on assets, and capital returns via buybacks and dividends.

The Investment Case for the Warrants

I have owned Wells Fargo through the warrants in the past, and bought them back during the August swoon when Wells traded down to 50 and the warrants got down to 17. What are the warrants? They are unique securities that were created by the government as part of the TARP Capital Purchase Program, where the government injected $205 billion of capital into the US banking system in exchange for debt securities, preferred stock, and in some cases, warrants to buy common stock.

The warrants are similar to deep in-the-money options, only with a very long time period before expiration as well as a few other small benefits. Originally held by the Treasury, these warrants were eventually sold at auction to the public and now trade on the NYSE. The warrants give the holder the right to buy a share of common stock between now and late 2018 for around $34 per share. The warrants have an anti-dilution clause which means dividends will reduce this strike price to around $33 by expiration.

I bought a decent amount when they traded down in August, but wish now that I would have really loaded up. I was somewhat reluctant to really back up the truck as I have sizable positions in a couple other banks. But I should have swung harder, and actually am considering buying more. With the warrant price around 21, the strike price around 34, and the current stock price around 55, it’s nearly free leverage so it allows me to keep a sizable cash position in the portfolio for other investments.

Buying the warrant is like putting a 30% “downpayment” (cost of warrant) on a share of WFC, but without having to pay any interest while I own the warrant and I’m not even required to pay back the “loan” (the value of the rest of the stock) if I decide to sell. I think the warrants of the big banks are some of the best investment opportunities in this market because of the quality of the underlying businesses, the value of the underlying common stocks, and the long-dated nature of the security itself.

Valuation

WFC had a book value of $33.69 as the end of the quarter, up 7% from the previous year. At low-teen returns on equity and factoring in the dividend payout, I think it’s a safe bet that WFC compounds book at 7-8% annually. This puts book value around $42 per share in 3 years when we will have to convert our warrants into common stock (or sell them). If Wells can do 13% ROE (historically low, but what it has been doing this year), the bank will earn around $5.50 per share. At 12-14 times earnings, this equates to a price of around 32 to 44 for the warrants, which are currently priced around 21.

I think that’s a pretty good return over the next 3 years—especially given that I think the downside chance of losing any money is extremely remote. Banks are much safer, much better capitalized, more streamlined, and their stocks are much more cheaply valued than the pre-crisis days. Short of an environment that leads to either severe financial stress and/or single digit P/E ratios (which is possible but not probable), it is unlikely these stocks will be lower in 3 years than they are now—in which case the warrants don’t lose. If ROE begins to rise a bit when rates rise, the returns for the warrants start to get extreme, but that doesn’t need to happen for the investment to work out very well.

I think Wells is the best bank among the big money center or regional banks—it’s not the cheapest and I think some other banks might offer more interesting returns, but I think it’s the highest quality bank of the group. I find these warrants to be attractively priced.

Disclosure: John Huber owns warrants to buy Wells Fargo common stock for his own account and accounts he manages for clients. This is not a recommendation. Please conduct your own research.

35 thoughts on “Wells Fargo and the Incredible Predictability of Deposit Growth

  1. Thank you for sharing your analysis of Wells Fargo with us. Being a data junkie, i enjoyed seeing the historical information about deposit growth, loan growth and industry profitability.

    I think that Buffett might also like banks because they have “float” – they receive money that needs to be repaid at some point ( deposits) and can invest them to earn money off it ( loaning it out). Of course, the lowest cost provider that also has smart loan underwriting can mint money ( along with cross-selling of services)

    As far as the warrants are concerned, at a price of $21.47 for WFC-WT and $55.03 for WFC, it looks like there is almost no option premium/time decay ( assuming a 33 strike conversion). These warrants also seem cheaper than Jan 2018 calls at strikes 30 and 35 (from a time decay point of view).

    1. Thanks for the comment. Yeah the warrants are very cheap, and give you more time than the 2018 LEAPs, and probably are slightly more liquid also. The anti-dilution clause also allows some modest value to accrue to the warrants with dividends over a certain amount. This should reduce the strike by $1 or so over the course of the next three years.

  2. I really enjoyed this article. My one concern would be the vagaries of Mr Market. One has to be prepared for major downturns in the stock market that could leave the warrants worthless. So there is a small risk for total capital loss that cannot be ignored. I noticed that Francis Chou has taken a similar philosophy and is long warrants for Wells, Bank of America and JP Morgan.

    1. Yeah you have to think of the position as a downpayment on the entire equity position. So if you lay out $21 for the warrant, you’re really buying one share of common for $55, but you’re only required to tie up $21 of capital. Obviously, the leverage means that your notional position is much bigger.

      1. Hi John, had a question- lets say you bought a large block of warrants with the intention of converting the full amount to common stock at the call date. Could this be financed at the call date, either through a brokerage or bank?

  3. Hi John,

    I’ve enjoyed reading your blog for some years now. This is by far your best post on banks to date. Like you, I follow banks closely. Wells has a low-cost structure in the form of core deposits. U.S. Bancorp, on the other hand, becomes a low-cost provider because its efficiency ratio is approximately 20% lower than its closest peer which is Wells. USB has taken the hint and is aggressively shifting their deposit base to a lower cost one. Combined with the lower efficiency ratio, USB in the future will likely expand its lead (i.e., moat) over its peers. And it’s priced approximately the same as Wells right now, as well. Just something to consider if you’re thinking about purchasing WFC. The warrant situation I follow less closely because, though I agree it’s unlikely a downturn occur circa 2018, I’d rather not take the chance because it is not within my area of expertise.

    I’ve spent some time looking at Bank of the Ozarks, as well, which has a higher ROA/ROE than both Wells and USB. The problem is it’s fully priced but it’s an interesting one to study. If you want to go through some of its footnotes with me some time shoot me an e-mail. I’ve entered it in the fields required to make this post.

    Regards,

    J

  4. Having low cost deposits is important, but so is earnings yield on loans. I’d much rather have Capital One’s 6.5% net interest margin than Wells Fargo’s 3%, even if they’re paying slightly more for their deposits.

    1. Yeah profit margins vary between different business models of course. So you have to consider the assets and how safe they are. There are many financial companies with higher NIM’s than the big banks, but they also might be prone to much greater losses. I don’t think this is the case with Capital One, but their asset base is much different than Wells, so I would factor that in. I wouldn’t really say that Capital One is a comp for WFC. If we were to go more extreme, we could say that Facebook has much better margins than Wells, which is true, but of course it all depends on the price you need to pay for those earnings, and how durable the earnings are. I think Wells is very durable. And I think the price–given the safety and durability and modest growth–is very fair, especially when provided with long-term non-recourse leverage that the warrants provide. I don’t have an opinion on Capital One. Might be a great situation, but I haven’t really looked at it.

      1. Perhaps you’re still thinking of Capital One as a mono-line credit card originator, but that hasn’t been the case since at least 2009. True their asset base is much different, but I think you’re getting paid for the additional risk. Honestly, I don’t think the business is at more risk than any other bank. Pre-provision pre-tax income is > 3% of assets, tangible common equity to tangible assets is > 10%, and loans to deposits is < 100%. Valuation is even better than WFC. COF is selling for 11x LTM EPS and 0.9x book compared to WFC's 13.5x and 1.6x. WFC might be a good investment at that price, but COF is better. You should check it out.

        1. The question as to whether Capital One is getting adequately compensated for the incremental risk they are taking on board is a difficult one. In addition, with a rise in interest rates it will be necessary to wait and see what impact that might have. I believe that it is difficult for the credit card issuers to pass along the increases in wholesale funding if their portfolios are basically fixed rate. They do have tools available however to manage that “gap”. Don’t know the mix between variable rate and fixed rate credit card products. I believe that the banks are better position to pass this along.

  5. I’d rather invest in smaller, regional banks between 2B – 10B in assets. I can understand their 10k’s and they basically take in deposits and lend it back out. I look for those trading less than book value. There should be much more consolidation in the industry as regulations make it too expensive for these small banks to comply.

  6. Hi John.

    Nice article, I will have to look closer at these warrants.

    Two questions come to mind, both surrounding interest rates.

    The Fed appears to be on the cusp of incrementally increasing interest rates. In such an environment of higher interest rates:

    1) do banks fair better? I.e. Does ROE improve, decrease or is it unaffected during these periods? I would imagine probably the latter because banks capitalise on the spread between rates, but I don’t know.

    2) how do you think equity prices will respond when the discount rate is higher? And does this pose a risk to exercising those warrants come 2018?

    Sorry, those are meaty questions.

    Thanks

    B

    1. 1) The answer is “it depends.” The mix of your loan portfolio dictates the direction of your ROA, ROE, and net interest margin in response to interest rate changes. This is classically referred to as asset/liability mismatch, and banks manage it through committees often termed asset/liability committees (ALCO). Currently, all banks are asset sensitive meaning ROA, ROE, and net interest margin expand in a rising interest rate environment. In contrast you can design a portfolio that’s liability sensitive, but it wouldn’t make sense in a 0 interest rate environment because rates cannot go any lower. Many 10-Ks will disclose how net interest margin behaves according to a 50 bp rise, 100 bp rise, or 200 bp rise in interest rates. Furthermore, they will differentiate it according to how quickly the rise occurs because loan maturity limits how quickly you can respond to interest rate changes.

      2) This is a bit controversial, but in my view, equity prices will decrease in a rising interest rate environment. As Buffett has said, “equities are very cheap if interest rates stay low.” That’s a big if. He’s made a similar statement during the .com bubble, but clearly he didn’t think interest rates would stay low.

      With regards to how bank prices will respond to a rising interest rate, if the bank is appropriately managed (as Wells Fargo is), unquestionably earnings will expand. The best banks are awash in liquidity currently and can extend loans if they payout is correct.

      One thing I’ll say to you, which I think is a nuanced point but very important: despite interest rates of 0, both Wells Fargo and USB exceed the ROE of the S&P 500. So even if interest rates stay 0 forever, these two companies should outperform the S&P in the long run (i.e., you’re buying them cheaper than the S&P and they’re more profitable). In all likelihood interest rates will rise and give profits in excess of the pessimistic case I described. The important thing to remember is that an investment in WFC and USB working out, versus the S&P, is not contingent on an interest rate rise. All of its other peer banks, on the other hand, requires interest rates to rise to pay off appropriately.

      As John so elegantly stated in his post, banking is a wonderful business when done properly and rewards shareholders accordingly over time.

      1. Thanks J,

        I don’t know a huge amount about banks but I know I want I park money there at some point in the near future.

        You gave me some good places to go and start looking.

        B

    1. I think the JPM warrants are probably the cheapest, and I think JPM has a significant moat similar to WFC. In fact, a lot of people talk about WFC’s low cost deposits, but BAC and JPM’s retail bank (Chase) also have very low deposits. I think JPM also has some other advantages in their other franchises. The valuation is lower at JPM (roughly 10 times earnings) because of the presumed higher risk of their investment bank and trading operations, but I think given the new regulatory environment and their much higher capital levels, they are probably much safer than the valuation gives them credit for. The bank, like WFC, is a cash cow. They’ll make over $20 billion again this year, and even with the higher required capital ratios, they’ll soon be returning sizable amounts of cash to shareholders. They are doing mid-teen returns on tangible equity, and book value is growing at upper single digits. If they keep producing 13-14% ROE, tangible book will reach roughly $60 in 3 years (8% CAGR), and if they maintain the same level of profitability they have now, they’ll be making around $8 per share. If they reach Dimon’s target of 15% ROTE, they’ll make $9. If they do $8 of earnings, this is an $80 stock at 10x earnings, which is roughly $38 for the warrants. If the P/E goes up just slightly to 11 or 12x, then we have an $88-$96 stock which means $46-$54 for the warrants. So although WFC is probably my favorite large bank, I think the JPM warrants have more upside given the earning power of the bank.

      Bank of America is reasonably valued also, but the nature of their warrants is not attractive. But I actually think much of the financial universe is attractively priced at 10-12x earnings given their much cleaner balance sheets and attractive earnings upside if rates begin rising. I still think there is a financial crisis “hangover” that has kept a lid of valuation levels of the large cap financials. This may be warranted, but I think valuation levels will rise ever so slightly as they continue to pound out steady earnings quarter after quarter. I think if we are in an environment where banks are becoming more “utility-like” (much higher regulated), then they probably deserve to trade closer to the level that regulated utilities trade. I doubt the big banks get to 15 times earnings, but at 10-12, they seem cheap to me given their ability to grow intrinsic value per share at close to 10% annually through a combination of increasing earnings and capital returns.

      1. Thanks for the response, John. Some interesting food for thought on the financial valuation hangover. I previously held a position in the BAC warrants with the thesis of their downsizing non-core areas, shift to low-cost deposits from high-cost debt, improving loan book, and upside to rising rates, but recently came to the same conclusion that the warrants just don’t offer enough upside for the risk at this point without a rate hike and sold out (I’m sure it’s a great time to buy now!). I like your logic behind the JPM warrants and will give them a closer look.

        The one thing that always eats at me with big banks is that the earnings seem so manufactured given all the assumptions and judgment calls required. Not saying they can’t be great investments (clearly Buffett showed they can), but how do you get comfortable with that? Do you just look for at the track record, analyze management and make a leap of faith?

      2. Thanks for the valuable insights. I am curious what exactly you mean on BAC that “the nature of their warrants is not attractive.” Are you saying they are not priced attractively relative to the common (warrant premium of 9%) or is there something else about them that makes them unattractive?
        thanks

        1. Yeah I think that because of the strike price in relation to the price of the common, they aren’t as attractive. The fact that you can buy BAC common for $17 makes the warrants less attractive as they have more time value than JPM or WFC and less leverage.

          1. Thanks for the response. How would you factor in the significantly lower dividend threshold for BAC warrants relative to JPM and WFC? Does that factor in your thinking on valuing the warrants relative to the stock?
            thanks

  7. Hey John,

    Just read your Mike Burry post – any chance you still have any of his old investor letters or original forum posts? Would love to read them.

    Cheers,

    J.R.

  8. Great article. Thanks. just on deposit growth, it’s probably similar to nominal GDP growth, which one would expect. In general I find it helpful to have nominal GDP growth in mind when looking at sales growth and even pricing power.

  9. Hi there…I keep coming back to this article. They dropped below $16 for a while today. Hope you had a chance to “load up”.

    L

    1. Yes, it’s a great time, and I did buy more. I will say that “loading up” on warrants is a relative term. Given the embedded leverage, the position size is much smaller than a normal stock position would have given the same level of conviction. But given the current valuation levels, I think these are great risk/reward ideas here.

  10. Thanks for the insightful analysis on your blog. Sorry for a naive question: wondering if you can elaborate on the intuition behind the consistent 60+ year deposit growth. What is the driving force? Why will the trend be sustainable going forward? Many thanks.

  11. I have decided to sell my Wells Fargo holdings as the news of opening fake accounts spread across. I sold them yesterday, after thinking about it for a few days. It seems these banks never seems to learn. I don’t know what other investors are doing or what Mr. Buffett is doing, but I’ve lost faith in this company now. I was holding the stock from almost 8 years.

    John, it would be interesting to know what you think.

  12. I can’t get this Buffett quote out of my head:

    “The best thing that happens to us is when a great company gets into temporary trouble…We want to buy them when they’re on the operating table.”
    (not sure of the original source, but I’ve heard it many times. Pulled it from here: http://www.suredividend.com/warren-buffett-quotes/ )

    Obviously WFC has some serious behavioral issues to resolve. At the same time I think the media frenzy and congressional grandstanding/showmanship are overblown and causing many to panic and forget about the actual business underneath it all. They do have ~$1.2 trillion in deposits at an average borrowing cost of 1 cent per $100 and they didn’t get into that position via the issues everyone’s currently discussing…

    https://www08.wellsfargomedia.com/assets/pdf/about/press/2016/first-quarter-earnings.pdf

    I bought more warrants…

    1. Buffett uses a wonderful metaphor of a gun with a million chambers in it with only one chamber which has a bullet in it. He then states that if someone offered to pay him any sum of money to put the gun on his temple and pull the trigger once, he will decline. No matter how high the offer, he would decline.

      What WFC has done is hand out a gun promising its empty when its not. This is risky AND unethical behavior at worst. Would WB walk the talk & sell?

Leave a Reply

Your email address will not be published. Required fields are marked *