Why This Financial Stock is Looking Good

Lee is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The first major bank reported on Friday and it’s time for investors to prepare for a busy week in the sector. Wells Fargo’s (NYSE: WFC) results were not universally well received but I thought they were okay. They were pretty consistent with the thesis that the US recovery is ongoing but tepid and they also raised a few pointers for investors to look out for going forward. There is always a tendency to get carried away in quarter by quarter movements, but I think investors should try to analyze events in the context of the economy. So here is my attempt at doing that.

Side With the Powerful in Order to Survive

The lesson that investors should have learned by now is that the banks only make money when the economy is working. In a sense, their highly paid salaries are a bit of a joke. They are paying themselves because the economy is good! The banks' lending ability and underlying asset base moves up and down with the cyclicality of the macro environment. When the economy is not functioning the authorities just redistribute resources in order to get things back on track so the banks can earn money again.

Even the banks with substantive trading interests like Goldman Sachs (NYSE: GS) and JP Morgan (NYSE: JPM) will never really escape this correlation. Why? Because I suspect Hell will freeze over before these banks learn the meaning of diversification. It is all too easy to join in trading in the directional trends in the economy, even if this means piling into mortgage backed securities after 2006 (when the US housing market had already started to decline). That’s the way it works folks and they are hardly likely to learn it now that they have been rewarded for failure! If you want trading risk then go ahead and look at JPM and GS, they are hardly expensive right now. If you want a more secure play in the US economy then WFC is a better bet.

Don’t Worry About Yield Compression

Okay. Rant over. However I do have a serious point here. If the banks' performance is a function of an improving economy, they have the political establishment behind them, and you think 2013 will be a decent year then why not look closely at investing in them?

Turning to the specifics of the WFC results, most of the commentary around the results is centered on the declining net interest margin (NIM).

The Q4 numbers are clearly disappointing from a superficial point of view. The decline was a more-than-forecast 10 basis points. This is a consequence of a low interest rate environment and older loans (which had a higher interest rate) being paid off. In addition, WFC saw strong deposit growth, which also helped to reduce the NIM. The latter accounted for eight bp reduction with a five bp reduction due to margin pressure. The three bp gain was from higher variable income. When questioned on the matter the management felt that the margin declines were moderating, so perhaps it will be less than five bp in the next quarter?

Who knows, and anyway does it matter in the scheme of things? Don’t get me wrong. Yield compression is an issue and you can see that in the net income figures. However, I think that in the bigger picture if the economy improves then history suggests it will not be a problem. Banks make money by lending and consumers and corporations want to lend when they feel better about the economy.

What the ‘yield compression worriers’ seem to be doing is projecting a static economy that is likely to carry on much as it has in the last few years. However, net household wealth is expanding and the housing market appears to be improving. Employment gains look assured and if Discover Financial Services' (NYSE: DFS) last set of results and commentary are correct the consumer is ‘done’ deleveraging. The conditions are ripe for a credit expansion.

Done Deleveraging and Refinancing so Where Next for Wells Fargo?

In a sense Discover’s view is both a negative and a positive for Wells Fargo. It implies that the consumer has finished deleveraging and looking for a ways to refinance mortgages. That’s not good news for Wells Fargo because refinancing activity is an important source of revenues for the bank. On the other hand, it is good news because the charge off rate is also declining and WFC feels emboldened to reduce provisions for bad debts.

On balance I think it is a net positive and the reason is that, on a historical basis, what usually follows now is an increased willingness amongst consumers to borrow. I think this is coming but investors will have to be a bit patient. This is an unusually slow recovery and WFC might see some worsening of NIM before it gets better. If I am right then this is just a transitional phase. In general things look good for the US financial sector in 2013.

They key is to follow the economy, and on the basis that WFC’s price/book ratio is much lower than it has been traditionally in recoveries, I think investors might want to stay the course here. WFC offers good exposure to the housing market. I'm happy to hold.


SaintGermain has positions in Discover Financial and Wells Fargo. The Motley Fool recommends Goldman Sachs Group and Wells Fargo & Company. The Motley Fool owns shares of JPMorgan Chase & Co. and Wells Fargo & Company. 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!

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