Should Value Investors Pounce on Wells Fargo?

A classic value-investment strategy is to take advantage of problems; or scandals, at a basically sound company. This stratagem works even better with scandals; or troubles, that are attracting a lot of media attention.

A lot of value investors are probably wondering if Wells Fargo (NYSE: WFC) falls into that category. The monster bank has been having some serious problems and generating a mountain of bad publicity lately. Almost everybody has seen the news stories that indicate its bankers were opening fake accounts – in order to meet sales quotas.

Now The New York Times is alleging that Wells Fargo management was aware of the problem as early as 2011, and exposed in The Los Angeles Times in 2014. The company even held an “ethics workshop;” in which it warned employees not to engage in the practice in 2014. It also employed so-called “risk managers;” in an attempt to root out the wrong doing. Despite all that employees were creating the phony accounts as late as 2016.

The efforts failed because workers had to create the fake accounts to meet sales goals to keep their jobs, former Wells Fargo Personal Banker Khalid Taha alleged in a Times interview. Sales; and not banking, became the main focus at Wells Fargo the Times is charging. Employees; including tellers, were fired for missing sales goals – while managers were receiving huge bonuses for hitting them.

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Is Wells Fargo a Bargain or a Time Bomb Waiting to Explode?

If true; the allegations are an indication of dysfunctional management, and a serious lack of ethics at Wells Fargo. Many investors will start wondering about Wells Fargo’s financial numbers.

Are they reliable or are investors being treated just like all the poor people victimized by those fake bank accounts. We might wonder are there other fake numbers at Wells Fargo that are driving its profits. How much of the 25.08% profit margin; and 4.05 diluted earnings per share number, reported on June 30, 2016 is being driven by snake oil?

Others will wonder if Wells Fargo is now a bargain, after all the fraud only occurred in one division of a vast enterprise. It may not affect other areas of the bank such as lending, or investment banking.

There is some merit to the bargain hypothesis. Wells Fargo’s stock price has dropped significantly since the scandal broke it was trading at $49.80 a share on September 8, 2016, and $46.54 on September 20, 2016.

That’s still a really great price for a company that reported revenues of $87.82 billion; and a net income of $22.39 billion on June 30, 2016. Yet it is also the company that reported a free cash flow of -$7.366 billion on June 30, 2016. The same day that Bank of America (NYSE: BAC) reported a free cash flow of $15.29 billion.

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Why Buffett Believes in Wells Fargo

Despite that Wells Fargo still has a lot of float in the form of $1.889 trillion in assets; $20.41 billion in cash and short-term investments, $137.50 billion in cash from financing and $11.84 billion in cash from operations on June 30, 2016. Wells Fargo is making a lot of money – which is why our friend Warren Buffett is so interested in it.

Buffett owns so much Wells Fargo stock that he lost $1.4 billion on September 13, 2016; when news about the phantom bank accounts emerged, Bloomberg reported. Buffett is Wells Fargo’s largest shareholder, The Street reported that he owns around 10% of Wells Fargo and has applied to the Fed for permission to buy more.

Uncle Warren is a firm believer in Monster Banks. He also owns large stakes in Bank of America and US Bancop (NYSE: USB). After the Wells Fargo scandal one might ask why? The answer is obvious: banks are where the money is, as legendary bank robber Willy Sutton once supposedly quipped.

Buffett’s thinking is that Wells Fargo has so much money; it can simply pay whatever fines and lawsuit settlements that stem from the phantom accounts scandal, and still have cash to spare. This seems like an obvious extension of Warren’s famed belief that a good business is one your idiot nephew could run and still make money. Here’s how he described in a 2010 discussion with the FDIC:

“If you’ve got a good enough business; if you have a monopoly newspaper, if you have a network television station — I’m talking of the past — you know, your idiot nephew could run it. And if you’ve got a really good business, it doesn’t make any difference.”

Perhaps we should extend that quote to say that a good business is that one either your idiot nephew; or your crooked brother in law, could run. It sure sounds as if somebody’s idiot nephew; or niece, is in charge at Wells Fargo.

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Buffett figures that Wells Fargo will survive the scandal and keep making money. Remember he thinks long term and buys for the future; Uncle Warren understands that the public (and Mr. Market) will forget about the phantom accounts in a few months, but Wells Fargo will still be there making money.

Ethics for Value Investors

This means that yes Wells Fargo is still a pretty good value investment, but it raises a serious ethical dilemma. Do you want to invest in a company that regularly rips off its customers; including depositors that trust it with their money?

That is a question investors will have to answer themselves. There are companies that make a lot of money; I will not invest in, because I find them unethical. These include pharmaceutical houses; which are in the business of gouging sick people (see Mylan (NYSE: MYL) for a textbook example), and tobacco companies.

The ethics are unfortunately a question you will have to answer for yourself. Wells Fargo is still a pretty good value investment despite the ethical problems. If they can be worked out – and I think they can. This bank will be a good long-term addition to a growth or income stock portfolio.