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Is Wells Fargo a Value Trap for These Hedge Funds?

The bank is still struggling to recover from its fake accounts scandal

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Rupert Hargreaves
Jul 27, 2021

Summary

  • Some large hedge funds own Wells Fargo
  • The bank has been struggling since 2016
  • It may never return to its former glory
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One of the most popular stocks among value-focused hedge funds is Wells Fargo (

WFC, Financial). Until a few years ago, Wells was a highly respected financial institution, which had a track record of creating value for its investors with share repurchases, dividends and progressive earnings growth. The company also benefited from its strong reputation among consumers, which apparently helped it cross-sell products, increasing profit margins.

As it later emerged, the company's success in cross-selling products was not entirely legitimate. In 2016, it emerged that the bank's famous cross-selling ability was built on the unauthorized opening of accounts with falsified records. Ever since this news broke, the bank has been fighting off a tidal wave of regulatory actions and lawsuits.

Regulatory action

In February of 2020, Wells agreed to pay $3 billion to the Department of Justice (DoJ) and the Securities and Exchange Commission (SEC) and admitted that it pressured employees to meet unrealistic sales goals between 2002 and 2016, which is what caused the fake accounts scandal.

On top of this fine, the group paid out a further $2 billion in other settlements and has been operating under a cap on the size of its balance sheet imposed by the Federal Reserve in 2018. This cap has done far more financial damage to the group than any of the fines. In August 2020, Bloomberg concluded that the cap had cost Wells Fargo at least $4 billion in lost profits, and this could be a conservative estimate. Based on year-end 2020 figures, Bank of America's (BOA) asset base has expanded by around $500 billion since the end of 2018, an increase of 25%. Most of this growth came last year.

As well as the asset cap, Wells' new management has also been selling off assets to try and streamline the business. One notable sale was the group's asset management arm sold to private equity buyers for $2.1 billion in February of this year. The division managed $603 billion for clients.

This sale was particularly interesting because in recent years, as interest rates plunged and banks' net interest margins have declined, many have expanded their wealth management divisions, which can be a lucrative source of income. Wells has taken the opposite path.

Only time will tell if this is a good strategy. Nevertheless, it is clear today that Wells' reputation is in tatters, the bank's former competitive advantage was built on illegal actions, the group cannot grow and it is selling businesses that provide some diversification.

Considering these challenges, it is no surprise the stock has produced a total return of just 1.7% per annum over the past five years and 1.3% over the past 15 years. Over the past five years, shares in the bank have underperformed the diversified bank sector by 9.7%.

Hedge funds like the stock

Despite all of the above, value investors such as

Francis Chou (Trades, Portfolio), Guy Spier, Michael Price (Trades, Portfolio), Thomas Russo, Thomas Gayner at Markel Asset Management and Charlie Munger (Trades, Portfolio)'s Daily Journal (DJCO, Financial) all hold positions in the stock.

I have no particular unique insight to explain why the value investors own the stock. They undoubtedly have their reasons, and a lot of them are smarter than me. Perhaps they expect the balance sheet cap to be lifted someday so that Wells Fargo can return to growth and become extremely profitable for the shareholders that have hung on.

However, I am conscious that the very definition of a value trap is that of a business that looks cheap but which has suffered significant structural change, impairing its ability to generate a profit permanently. When I look at the challenges Wells faces today, I think its profitability has been permanently impaired by reputational damage, legal issues and asset sales.

Unless the balance sheet cap is removed and interest rates rise significantly from current levels, I think it's difficult to see how the bank can ever return to historical levels of profitability and compete effectively with much larger peers such as Bank of America (

BAC, Financial).

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Disclosures

I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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