Complexity Spells Trouble for These 2 Financials
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Investors should learn to hate complexity, especially in financial sector stocks. The hubris of the financial supermarkets concept, which was popular before the financial crisis, is becoming popular again.
Worse yet, many financial companies are being pushed in new directions because they cannot generate earnings lending. Wells Fargo (NYSE: WFC) and UBS (NYSE: UBS) in particular are branching out to new revenue sources.
Expanding Into Investment Banking
Wells Fargo’s credit profile was adversely affected by its role in financing the $23 billion purchase of H.J. Heinz, as it displays the lender’s risk being stretched across investment banking. As per the Heinz deal, the company is planning to expand its securities unit and investment banking services in an attempt to grow higher advisory fee revenues.
According to Moody’s Investors Service, clients usually require financing of debt before signing as advisers. Moody’s also said that the bank desires to win the coveted advisory business that would increase the underwriting commitments as compared to those commitments in which the bank might ordinarily engage. After taking the debt on to the balance sheet there is a risk that bank cannot unload it. Wells Fargo CEO John Stumpf stands by increasing the securities to boost revenue ahead of traditional lending.
The company, along with JPMorgan Chase, has agreed to provide $14.1 billion to assist Berkshire Hathaway's (NYSE: BRK-A) and 3G Capital’s buyout of Heinz. Both the banks would serve as advisors. Berkshire is also the largest shareholder of Wells Fargo. According to Jessica Ong, a company’s spokeswoman, “We do not agree with Moody’s assertion that participation in capital markets activities necessarily leads to a higher risk profile. Wells Fargo has strong risk-management practices and a strong credit underwriting discipline and this transaction is fully in keeping with these disciplines and with our customer-focused business model.” The company may also plan to expand its trading businesses to distribute the debt it underwrites, which would wear down the force provided by the bank’s branch network.
Berkshire Leading the Way
Berkshire Hathaway itself is something of a trend-setter when it comes to embracing wild investments. Berkshire Hathaway’s fourth-quarter profit increased by 49% on gains related to derivatives wagers. The company’s net income increased from $3.05 billion, or $1,846 per share, during the previous year to $4.55 billion, or $2,757 per share, while the profit on derivatives increased from $163 million to $1.4 billion.
To speculate on long-term gains in stock-market indexes in Europe, Japan and the US, Buffett used index put options. As they won’t be settled for years, the probability of the company booking a loss on these contracts is very low. He also said that, “These derivatives have provided a more-than-satisfactory result, especially considering the fact that we were guaranteeing corporate credits – mostly of the high-yield variety – throughout the financial panic and subsequent recession.” At the end of December 2012, the book value of the company increased to $114,214 per Class A share as compared to $111,718 three months earlier.
During the fourth quarter, the insurance business had an underwriting loss of $19 million due to Superstorm Sandy-fueled claims as compared to a loss of $107 million during the previous year. Insurance investment income also decreased to $805 million from $825 million during the fourth quarter in 2011.
In 2010, his biggest acquisition, railroad Burlington Northern Santa Fe, was a $26.5 billion transaction. The business contributed $932 million to the current quarter’s earnings as compared to a $909 million contribution during the last year. The impact of fewer coal shipments was mitigated with the help of an increase in shipments of construction products and petroleum. The company’s manufacturing, service and retailing segment contributed $829 million to earnings, which was low as compared to the $856 million profit booked during the previous year.
The move into investment banking to generate fees is not exclusive to parties in the Heinz deal. UBS-acquired Link Investimentos, a Brazil-based brokerage company, has gained the maximum market share in cash equity trading due to a fall in fees accompanied by increasing competition. In February 2013, UBS completed the acquisition of Link; it is looking to take an advantage as equity trading in Brazil reached a record, luring competitors, including Goldman Sachs, Barclays and private-equity funds such as Actis and General Atlantic.
According to Daniel Cardoso Mendonça de Barros, the CEO of UBS, “New foreign competitors invested in Brazil, fueling the war to gain market share. Fees for brokerage firms have been falling about 20 percent a year for the last couple of years, and today only about 10 brokerage firms are making money out of the 96 in BM&FBovespa.” According to Coalition, various global banks such as UBS are facing pressure to increase their equity-market share and reduce costs after revenue from the business across the industry decreased by 5% during the previous year, the third continuous annual drop.
Since deal making could be the wave of the future for Wells Fargo and UBS, we should compare their valuations to incumbent stocks:
Wells Fargo and UBS are not attractively priced when compared to Barclays or Morgan Stanley. Both of these firms trade at half the revenue multiples and book multiples of UBS and Wells Fargo.
Investors should not flock to Wells Fargo nor to UBS based on their ventures into investment banking. On the contrary, there are cheaper financial companies whose prices already reflect a healthy fear of complexity. At today’s prices, Morgan Stanley or Barclays would make better speculative bets.
BillEdson11 has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!