This is the third and final post on the Banking on Trust series. While the previous post winded down to an extraordinary length I recognise it lacked the practical treatment. I hope to set it out right this time. For the first part see here and the second part take a peek here
The last post, Banking on Trust-2 can be summarised in four words- “Management maketh, Management breaketh.”
Due to the highly discretionary job of risk management and a fragile business model (need plenty of other people’s money to even work) a good management can be the invisible asset for a bank.
And I argued, though admittedly without much proof, that Wells Fargo Corp’s management has been extraordinary in its handling of the business.
Let us attack the issues one by one.
Competitive Advantage 101
What separates a big 4 bank (Wells Fargo, JP Morgan Chase, Citigroup and Bank of America) from community banks?
Short Answer: Scale
Long Answer: Economies of Scale.
Being larger in size Wells Fargo and Company (WFC) is able to keep its fixed costs per unit of loan disbursed far lower than its local competitors.
With lower fixed costs, it is able to charge lesser interest on loans disbursed thus winning the first battle in a commodity business.
What prevents the community banks from growing into a big 4 bank?
Short Answerr & Long Answer: Search costs for customers
The incumbent banks have been able to offer full services at a lower cost (due to scale) than community banks. As a result for a customer it is difficult to find a substitute of such a bank which offers all those services at lowest prices. And hence community banks stay ever small.
The management of WFC understands these ideas very well. Yet they have taken their execution to a completely different level. By being one of the first banks to repeatedly innovate its financial offering (keeping in view changing regulations as well as customer needs) it has performed extremely well.
A history of success of WFC
1967: WFC introduces a Mastercharge card as a new form of credit card.
1968: Under high inflation, FED restricts overseas spending. But outbound customers and expats need a solution to this new regulatory development. WFC recently opened London subsidiary WESTERN AMERICAN BANK swings into action- servicing the clients and turning in better than expected performance.
Converts to a federal bank charter (Community Banks- 0, WFC-1)
Mastercharge credit cards which turn out to be a success. Adopted in 37 States and used by 13million cardholders. These numbers generate substantial benefits for WFC. Accepted by virtually every major oil company.
1970: WFC organised as a bank holding company to broaden their services. New branches opened in Sydney, Hong Kong, Luxembourg, Mexico City, Managua etc.
1975: Its market share of the retail savings trade increased more than two points, a substantial increase in California’s competitive banking climate. With its increased deposits, Wells Fargo was able to reduce its borrowings from the Federal Reserve, and the 0.5% premium it paid for deposits was more than made up for by the savings in interest payments.[from wiki]
1978: Fed allowed banks and thrifts to offer savings intruments with interest rate linked to T bills (savings rate deregulation). Wells Fargo quickly deregulates its own savings rate. Launches two new plans in response to this. Automatically allows savings account interests to be moved into checking accounts.
1978-80: Wells Fargo’s investment services becomes a leader. More accounts garnered than any other money manager. Wells Fargo’s early success, particularly with indexing—weighting investments to match the weightings of the S&P500—brought many new clients aboard.
In short,with a rise in offerrings WFC is constantly increasing the search costs for customer. But the management of WFC has one more ace up its sleeve.
A mental model to analyse Mastercharge
But wait a second here!
Are we missing something?
Yes surely we are! We missed an important development.
In 1967, WFC launched a system of transaction where customers can take credit from their banks for purchasing items. It was named Mastercharge.
Lets first explore, the success (if any) of Mastercharge as of 1969.
37 states out of 51 adopted it.
13mn customers use it.
Almost every major oil company supports it.
Can we make a reasonable guess on the future of Mastercharge? Its benefit to WFC?
Surely we can. Mastercharge is nothing but the first credit card offering in the world. It is essentially making its customers dependent on itself!
Thats the classic case of moat. Think about it! Marlboro, Coke, See’s Candies. All are businesses which will be sorely missed by its customers.
Lets attack it from another perspective. Lets check if it can be lodged off from its perch (13mn cardholders, acceptance by major oil co.) by a new competitor.
Have you heard of Replicator Dynamics? It is an interesting mental model.
Its in essence a system which says- folks adopt those behaviours more readily which has the more payoff (the material aspects) AND is copied by more number of people. So we can see- people switching and adopting new behaviours. Something like people coming from different cultures quickly adopt the cultures of their new country.
I will be talking about this mental model in another post (Stay tuned!)
Lets apply it here.
Assume that Mastercharge gets a new competitor called Surcharge. It is the new kid on the block. Zero people use this and no states have adopted it, yet.
Now Alex wants to enroll in one of the two credit card companies- Mastercharge or Surcharge.
What does Alex see? Alex sees around him 13mn customers already using Mastercharge.
13mn cardholders of Mastercharge!
It effectively means wherever Alex looks, he sees every card holder as a Mastercharge holder. He is surely going to adopt that behaviour which is being followed by others [Replicator Dynamics].
But when 37 States and all the major oil companies have adopted Mastercharge, what does it imply?
A large number of vendors are already using it. So for Alex, Mastercharge has clearly become significantly beneficial.Its the classic Network Effect at play.
Each new vendor when joins the network makes the network more valuable to its individuals (Think Facebook in 2006 and 2014).
So for Alex, not only does it make more sense for him to adopt Mastercharge than Surcharge, it also makes it more profitable to him (i.e. gives him disproportionately large material benefits than Surcharge).
Thus we see, Mastercharge owning the market, like a boss!
Mastercharge finally became -> this
The ace up Wells Fargo’s sleeve
The management perhaps thought, if I am indeed locking away the community banks in services why not go the entire way!
Lets lock them out of physical proximity to customers as well!
Take a look:
Dotting the California: New Branches opened or pending in 1968
Its opening new branches so close to each other that it is effectively crowding out community branches.
In the same year it merged with Bank of Pasadena (a 10mn $ deposit bank), Azusa Valley Savings Bank and First National Bank of Azusa (combined 11mn$ deposits).
It acquired Sonoma Mortgage Corp.
In 1969, Wells Fargo has 19 offices in Southern California, the deposits exceeded 165mn$ and loans topped $230mn.
Offices in South California
In 1970, the conquest of Los Angeles and Orange counties(right) is shown. And also take a look at the San Jose metropolitan area expansion
The Conquest of South-West America aka LA and California
So we see an all out attack to disproportionately increase the search costs in every way possible.
The qualitative aspects are done, let us train our guns on perspectives.
Is the management really running a tight ship?
Is it keeping its costs down?
In contrast BofA had an overhead margin of 47% in 1998 inspite of 100 years+ of experience
The management- does it go bonkers in good times?
With the qualitative aspects out of the way, let us consider the quantitative aspects of management i.e. its ability to make conservative loans, predict their vulnerability and make the right amount of provisions so that, I repeat, so that the net operating profit after tax is smoothened.
Take a look at this:
The NOPAT barely nudged even in a downcycle
What I did was simple.
I took the Net Interest Income subtracted only the charged off loans so that I get the true picture of ‘damage’ in the current year and added back the loan provisions.
Remember loan provisions exist to smoothen out bad loan losses. So ideally management should have anticipated the loan provisioning properly so that charged off loans are fully accounted for.
But probability of loan going bad is a combination of expected and unexpected developments.
Hence how good a management is, can be checked by how good its predictions are.
In turn, how succesful it had been in making its NOPAT smooth.
Since provisioning is tax free, I adjusted the tax accordingly. Taxes paid in real is the second row, and the last but second row are the taxes applicable on our adjustments, given the same tax rate.
Take a look at NOPAT levels again.
Remember in the period from 1970-72 US entered a recession.
With each economic downturn banks are the first to suffer losses.
And yet, Wells Fargo’s NOPAT has barely nudged.
What do we conclude?
We do conclude that Wells Fargo’s management has been extraordinary capable of cushioning the bank’s fortunes from macro economic shocks. WFC- 1 , Competitors – 0
So now it comes down to valuations. Lets take a look!
Valuations- Valuing the Wells Fargo!
It went public in 1972, and its average market cap for that year was around $1.5bn.
What growth expectations are we attaching to Wells Fargo?
Lets first try to establish a way to value this company.
We adopt the Economic Value Added (EVA) methodology to analyse this bank.
EVA = NOPAT – Shareholder Equity * Cost of Capital
Market Value of Enterprise = Shareholder Equity + Future Value of all EVAs
Using this framework, lets try to find out the EVA from 1967-1971. The cost of capital for a shareholder is merely the opportunity cost.The second best idea is investing in index, assuming a blank portfolio.Consider it to be the historical growth in index DJIA from 1940-1970. Thus the cost of capital equals 8%.
Hence plugging it in and assuming a 20% growth rate for the next 30 year, we arrive at its 1972 valuations of $1.5bn.
20% growth rate in EVA, discounted at 8% for the next 30 years.
Is it too costly?
Well it is if you see the time duration involved. Growing at the rate of 20% for the next thirty years is not a mean feat!
However if you consider that this is a good business, with a responsible management at helm, with very interesting offerings like Mastercard and a deepening moat, then you might like to reconsider your position.
But I will be fair. Had I been in 1972, I wouldnt have dared to buy it. But given the mental model working in my head now, I would have surely stalked this company very closely.
Three Years ahead- August 1974
Let us consider three years ahead.
Has the position worsened?
In 1974, Wells Fargo NOPAT was $66mn.
Equity stood at approx 450mn$.
At a cost of capital at the same 8%, we have EVA of Wells Fargo in 1974 at $30mn.
If we assume the growth rate in EVA to be about 8% for the next 30 years, the future value of all EVAs come to $0.9bn. With the shareholder equity standing at $450mn, the market value of the enterprise comes to $1.35bn.
In 1974 for about 4-5 months (from August-December) it traded at a marketcap of $860mn.
Fours more years ahead- 1978
Let us go four more years ahead. How well would we have fared in our assumptions?
Constantly increasing Earnings and Dividend per share
It clocked an average of 18% growth in the last 5 years. Topline growth has clocked an average of 17%.
And has the moat deepened?
Everincreasing return on shareholder equity! What else is it other than deepening moat. And this has come at the cost of dumb competition.
Remember Walmart? Walmart did the same with mom and pop shops.
But ladies and genetlemen, I will completely understand if you are hungry for some more.
Take a look at this:
Increasing return on assets for WFC. Almost a vertical line!
And take a look at its effect on leverage:
Falling leverage implies better asset utilisation and deepening moat.
It just shows one thing- Wells Fargo and Company will continue to make a heck lot of a money for its shareholders. In fact, from 1974, if you would have bought and held WFC it would have returned 29400% ; compounded yearly at the rate of 15% for the next 40 years.
Think about it.
1. John Hubers excellent posts on Wells Fargo which has served as an inspiration to conduct this study. here, here and here
2. Annual reports of Wells Fargo from 1968-71,1978,1988,1998
3. The featured image is taken from John Huber’s wonderful blog Base Hit investing