Why This Hated Bank is Still My Favorite Stock in the Sector
Headline risks can strike at any time and can hit even the best investments. Most companies have felt the pain of a news story that sent shares plunging, and when the issue results in little more than a humiliation for management, it can turn out to be an opportunity for investors.
That’s the case with my favorite bank stock, Wells Fargo (NYSE: WFC), which is the largest bank in the country by deposits and underwrites more than a third of the nation’s home loans. The bank’s focus on lending rather than asset management has helped it outperform other large banks with nearly 60% of its $1.7 trillion in balance sheet assets in consumer and business loans.
News broke in early September that more than 2.1 million fake deposit and credit card accounts had been opened by employees of the bank. This was done primarily as a way to meet high quotas for cross-selling products, and only about 5% of the fake accounts generated any fee income, which totaled $2.4 million.
Aggressive cross-selling of products is nothing new in banking. The problem is that Wells didn’t have the oversight structures in place to catch employees committing the fraud.
The Consumer Financial Protection Bureau (CFPB) and other agencies have fined Wells Fargo $185 million, and federal prosecutors in New York and California have opened criminal inquiries. More than 5,000 people at the bank have lost their jobs, about 2% of the total employees, and California and Illinois have banned Wells Fargo from underwriting state and municipal debt for one year, though several other states have announced they will continue to do business with the bank.
CEO John Stumpf has been grilled by Congress over management’s lack of oversight, and presidential candidate Hillary Clinton has promised to hold Wells Fargo accountable for its “egregious corporate behavior.”
But while the bank’s reputation has taken a hit and shares are down roughly 10% since the news broke, this scandal is unlikely to have a significant longer-term impact. In fact, the firings may actually help cut costs.
WFC is still one of the most widely held U.S. banking stocks, and the financial institution has long stood out for its customer service. Warren Buffett’s Berkshire Hathaway Inc. (NYSE: BRK-B) is the bank’s largest shareholder, owning almost 10% of the company.
A Morningstar analyst did a review of the CFPB database of customer complaints and found just nine complaints for every $1 billion in deposits at Wells Fargo. He noted that large regional competitors like Regions Financial (NYSE: RF), SunTrust (NYSE: STI) and Citizens Financial (NYSE: CFG) had a more than 50% higher CFPB complaint rate than Wells Fargo.
The fines and lost revenue to near-term underwriting bans pale in comparison to the bank’s total business. For instance, the bank saw $13.7 billion municipal bond underwriting business in the first half of the year, and California accounted for approximately 11% ($3.9 billion) of that.
Meanwhile, Wells Fargo booked $87.8 billion in net revenue over the past year and has $193 billion in shareholder equity. The bank returned $8.98 billion in cash through its dividend and bought back $8.35 billion in shares in the past 12 months.
Wells Fargo is scheduled to report earnings on Oct. 14. I expect a big mea culpa from management but no real changes to their outlook. They will likely talk about what went wrong and outline steps they are taking to ensure nothing like this happens again, and that could help restore investor sentiment.
Generate 20% in Annual Income While Others Wait for a Rebound
While shares of Wells Fargo are now trading at a 10% discount to where they were less than a month ago, the real opportunity may lie in the increased volatility.
In the three months before the scandal hit shares, volatility in Wells Fargo was just 18.9% on an annualized basis versus 26.7% for the SPDR S&P Bank ETF (NYSE: KBE). Since Sept. 8, volatility in WFC has increased to 20.1%, while volatility in KBE has decreased to 16%.
While an increase in volatility denotes more risk for shareholders, there are a number of strategies that capitalize on this, including a conservative income strategy known as selling covered calls.
A covered call involves purchasing at least 100 shares of a stock and then selling a call option on that stock to collect income, known as a premium. When volatility is high, options premiums go up, allowing traders to collect more income.
Selling a covered call on a stock means a few things:
1. By selling a covered call, you agree to sell 100 shares of the underlying stock at a specified price (the strike price) at a specified date (the expiration date) if the stock is trading above the strike price.
2. The income you receive for selling the call is yours to keep no matter what.
3. The income lowers your cost basis on the shares and helps protect you if the stock trades lower.
Let’s look at how this works with Wells Fargo:
With WFC trading around $45 at the time of this writing, we can buy 100 shares and simultaneously sell one WFC Nov 45 Call, which is trading around $1.26 ($126 per contract). This lowers our cost basis to $43.74 per share, giving us about 3% in downside protection.
If the shares close above the $45 strike price at expiration on Nov. 18, our shares will be sold for that price. In this case, the $1.26 premium plus the November dividend of $0.38 gives us a total profit of $1.64 a share for a 3.7% return over our cost basis of $43.74.
Now, consider than we’d earn that in less than two months. If we could sell a call for about the same price every two months, we could earn a total of $9.08 per share in income in a year, including dividends. So, even if shares never budged an inch, that income would give us a 20.2% yield on one of the best names in the banking sector.
Covered calls aren’t just for active traders. They are simple and safe enough for retirees. In fact, one group of regular investors is using this strategy to pocket an $3,000 a month in extra income.