Wells Fargo: Is Wall Street Underestimating Their Future Earnings?

Wells Fargo's (WFC) stock appears to be trying to break to a new high. Could this possibly mean that Wall Street is underestimating their earnings over the next couple of years? Recently I wrote a blog offering my thoughts on when the big banks would begin hiking dividends. In doing research on that blog, I stumbled across a presentation that Wells Fargo made at the Credit Lyonnais Asia Conference. Wells Fargo's presentation at the conference was one of the most upbeat presentations of a bank that I have heard in a long time. It wasn't a pep rally, but it left a clear picture of the strategy that the company is employing to return to solid earnings growth. In two words that strategy is cross-sell and market share expansion. WFC's culture has been wedded to the concept of cross-selling multiple products to their customers going all the way back to the old Norwest days. In the recent meeting, they said their average cross sell was now up to 5.95 products per customer. What was most interesting was their discussion of their Wachovia acquisition and the roll out of the WFC cross-selling program within Wachovia. It seems Wachovia's cross-sell average is about 4.6 products per customer. CEO John Stumpf, spent a lot of time discussing the opportunities of moving Wachovia's cross-sell average up to WFC's average. He said it would increase revenues on the Wachovia business by nearly 30%. And he wasn't just talking about the opportunity, he described WFC's ongoing program to accomplish this growth. Not surprisingly the growth plan had many moving parts primarily related to training and incenting employees to the WFC way. What was surprising was the number of new employees that were being added to former Wachovia branches. This was surprising because WFC is noted as a low expense-ratio bank and adding lots of new people in branches would seem to be counter to expense control in these difficult times. Stumpf made it clear that WFC was using these bad times to take market share. Listening to Mr. Stumpf, it was clear that they were being selective about what new business they went after, but it was equally clear that they were aggressively competing to expand their business footprint in every market in which they served. The final chapter on how the financial debacle of 2008-2009 will turn out has not been written. It may be years before loan losses can return to historical trends. Certainly, WFC has plenty of problem loans, but Mr. Stumpf convinced me that WFC had sufficient capital and reserves to handle their problems. One day the banking crisis will fade from the front pages and lending will not be seen as such a treacherous undertaking. When that day comes, my guess is WFC will have been the big winner in gaining market share in the United States. From the looks of the price graph above, there are many investors who believe Wells Fargo is on the right track. With any kind of luck, it will break to a new intermediate high, joining GE and further signaling that investors are trying to put the subprime crisis behind them. We own WFC. Please see Conditions of Use on the right side-bar.

Is GE Signaling Stocks Are Going Higher?

Our Investment Policy Committee spent most of last week's meeting discussing whether or not the stock market may be at an inflection point that could lead to significantly higher prices. There were five key points running through our discussions.

1. 80% of S&P 500 companies beat their earnings estimates for the fourth quarter, much higher than expected.
2. Fourth quarter US GDP growth significantly exceeded expectations at 5.9%.
3. Economists surveyed by Bloomberg are now estimating 3.0% GDP growth for 2010, up from 2.5% at the beginning of the year.
4. Fed comments continue to paint a benign picture for inflation, meaning that rate hikes are not likely before the end of the year at the earliest. Economists are still forecasting that core inflation will be 1.3% by year-end 2010. This benign inflation data flies in the face of the gold bugs and those who believe that runaway inflation is a foregone conclusion.
5. The price action of General Electric (GE) is impressive.

Perhaps the most significant part of our discussion of the five points was related to the recent price action of GE. GE has recently broken above a several-month trading range on high volume. GE has many qualities that make it something of a microcosm of the US economy. Thus, it's price breakout suggests that worries about its loan losses and perhaps loan losses for financial companies in general might be peaking. These five points do not suggest that stocks will soar again in 2010 like they did in 2009. The reason is simple: we could just as easily assemble another list containing at least five powerful negative forces facing the market. Yet, investors are certainly aware of all of the negatives, and because of this we believe the price action of GE in recent days is an important signal.

GE has been in the middle of the financial crisis, and for it to power to a new post crash high (see chart above) is big news. We've watched price graphs long enough to know that some very big money has just made some very big bets that the news for GE is going to get better over the coming months.

Additionally, because GE's business is so multi-faceted, there is reason to believe that good news for GE is probably good news for the whole economy and stocks.

Interestingly, GE had a couple of big days right after their CFO announced that the company was considering a dividend hike in 2011. In this regard, their message is similar to the one we suggested in last week's post about the banks. That is, companies, even companies in the financial services sector, appear to feel comfortable with their current levels of capital reserves. When GE starts talking about dividend hikes, it sends a clear message: they don't have any dilutive equity capital underwritings in the works. That is good news, but even more importantly, if they are talking dividend hikes, it follows that they must see an end to their loan losses. That's even better news.

We own GE. Please see conditions for using this blog on the right sidebar.

When Will the Big Banks Start Hiking Dividends?

Federal regulators are apparently telling the major US banks not to hike dividends or start share buyback programs anytime soon. The regulators want the banks to keep their capital ratios high because of the continuing loan losses the banks are experiencing. That might mean that the government's interference may push dividend hikes into next year. Having said this, I believe the banks are under increasing pressure from long-time, income oriented share holders to start hiking their dividends. The banks also know that most of these shareholders will begin to sell if dividend hikes are not forthcoming soon. In light of these two opposing forces, we think banks will start talking more and more about dividend actions they plan to make, when they get the "green light" from the regulators. Some US banks may do as corporations often do in Europe by giving guidance about dividend hikes six months to a year in the future. Because I believe dividend hikes from banks will ultimately come, I am offering my thoughts about the current dividend-paying ability of the largest banks. I have studied the most recent financial statements of the five largest banks in the United States; the following are my predictions of the order and time frame in which they will begin to raise their dividends. 1. JP Morgan -- JPM is my number one pick to hike their dividend in 2010, unless they are prohibited from doing so by the regulators. JPM's total loan loss reserves appear to have peaked and their existing loan reserves are far in excess of their recent loan loss experience. 2. Wells Fargo -- WFC's loan losses also appear to have peaked and management has voiced a desire to raise the dividend. The only problem is WFC's balance sheet. It is a little light in excess capital. Still I believe the company is anxious to reward its shareholders. Thus, I would not be surprised if some token dividend hike was initiated as soon as the regulators approve it. 3. US Bancorp -- The company would probably raise their dividend today if the government would permit it. They have the reserves and the will to hike dividends as soon as possible. 4. Bank of America -- BAC's massive capital build in 2009 nearly doubled the number of their outstanding shares. I believe BAC's first order of business will be to initiate share buy-backs to begin the process of reducing their shares outstanding. Even if they were allowed to, I do not predict they would hike their dividend in 2010. A dividend hike of some modest amount should be forthcoming in late 2011. 5. Citigroup -- I just do not see a dividend hike for C anytime soon. Like BAC, they also issued massive numbers of new shares in 2009. Thus, I think C will concentrate on share buybacks for the foreseeable future. The banks are not clear of loan loss problems, but the losses appear to be slowing and profits from their investment banking operations should produce positive earnings in all of the major banks for 2010. Interestingly, if the banks do start talking more definitively about future dividend hikes, their stocks would likely rise. On the contrary, if banks clam up about future dividend hikes, their stocks are likely to continue to be range bound.

In Search of a One Ring Circus

My first visit to the circus was a big disappointment.  I can't remember when or where it was, but I remember that it was a three-ring circus in a small town in Southern Indiana.  I remember to this day the anticipation as I walked toward the huge tent and heard the sounds of hundreds of circus-goers pouring out into the steamy summer night.

Everything about the night was great until the actual circus began and I tried to watch the acts in each of the three rings.  After about thirty minutes, I was exhausted and frustrated because I found that, at least for me, it was impossible to see any of the acts when I tried to see them all.  I decided that I would need to watch only one act at a time if I was to enjoy it.  The frustrating thing about this approach was that my attention was constantly being drawn from the act that I was watching by the ooohs and aaaahs that I heard coming from other people watching the other rings.  I remember the distinct feeling that what I needed was a one-ring circus.

I've revisited that old desire for a one-ring circus in recent weeks relative to the economy and the markets.  It seems as though we have been forced to endure a three-ringed economic circus since the first of the year as three major events have been playing themselves out:  1. the health-care debate and its effect on the economy, 2. the debt crisis in Greece and other European countries; 3. the almost fantastic fourth-quarter earnings results of US companies.

I admit that I have spent many hours trying to analyze the true effects of the government take over of health-care.  I believe there is no question that the government takeover of health-care will slow economic growth in the US.  Nobody really knows by how much, or when its full effect will be felt, but no economist I follow believes that economic growth will benefit as a result of the new health-care plan, should it become law.  Yet, while the healthcare plan might not be good for the economy and jobs, its effect on corporate profits is less clear.  Nearly 50% of S&P 500 earnings come from outside the US.

I have thought from the very beginning that France and Germany would bail out Greece.  These two countries are dedicated to a Greater Europe strategy for political and economic power and they are not going to let a small country like Greece derail their agendas.

These two rings of the circus both may be moving toward closure, but their ultimate effects will come to bear years in the future.  Therefore, I have begun to focus more of my attention on the final ring of the current three-ring circus: corporate earnings.  Corporate sales and earnings in the fourth quarter rose for the first time on a year over year basis since mid 2007.  Eighty percent of companies beat their earnings estimates.  This was not a case of less bad; this was a case of genuinely better earnings.  Thus, I have to conclude that in the face of a very slow economy US companies are doing an extraordinary job of generating free cash flows.

This uptick in earnings has largely been ignored by the market, which is about where it was at year end.  That means that the S&P 500 is now trading at about 13.5 times projected 2010 earnings.  In the current low interest rate environment, the appropriate PE should be at least 15 times, if not higher.

If investors can get their minds off of the two rings of the economic circus that will take years to evaluate, and focus on the good news of corporate earnings in the here and now; I believe a significant rally would result, perhaps as much as 15%-20%.

Two Stocks That Are Not Cheap

We are dividend investors and lost among all the talk about dividend investing is the subject of valuation.  We say that dividends are important for two reasons: 1. They have represented almost 50% of the total rate of return of stocks over the last 50 years; and 2. In many cases dividend growth is highly correlated with price growth. 

We can conclude from these two facts that correlation modeling can reveal the "normative" value of a stock at any point in time.  This of course does not mean that these normative valuation models can predict the future, nothing can do that; but it does give us a good idea of how the market has valued a company's dividend profile in the past. That coupled with the fact that dividends have been approximately one-third as volatile as earnings over the long-term, in our judgment, gives us the best guess possible about the approximate value of a company. 

The "unknowns" have been winning the battle against the "knowns" in the economy and the markets in recent months.  In this environment, it is not surprising that the Processed Food Industry group has flourished.  Not only is the group defensive in nature, but also with such a weak economy, investors are betting that more meals are being eaten at home than away from home.  Thus, the Processed Food group has been riding high. 

Our dividend valuation models, however, suggest that the group may now be discounting all the good that is likely to come over the next twelve months.

The two charts above are of Kellogg (K) and General Mills (GIS), two leaders in the Processed Food category.  The red lines are the anual price movements of the two stocks and the blue bars are the annual dividend valuations based on a multiple regression of their stock prices versus dividend growth and interest rates. 

The picture is nearly the same for both stocks.  They ain't cheap.  The price lines are now above their current dividend valuations, but more importantly, their current prices are above their projected growth in dividends and valuations (the striped bars) over the next 12 months.  In short, to our way of thinking, these two stocks, and many others in the group are not cheap.

Oddly enough, the Household Products group, not shown here, which includes Procter and Gamble (PG) and Colgate (CL), is still selling far under its dividend valuation.  We'll be watching for a shift away from the Processed Food group to the Household Products group in the weeks and months ahead.

We own CL and PG.  Please see Conditions of Use of this blogsite on the right side-bar.

A Rate Hike That Wasn't

After the close of the market today, the Fed raised the "discount rate" by .25% to .75%. Headlines immediately appeared on many Internet sites that the Fed had begun the process of tightening interest rates. Stock futures fell by 1%. Mr. Bernanke tell us it IS so; tell us that you have evidence that we do not yet see. Evidence that the economy is improving enough to start hiking rates. From the cliff hanging experience of 1929-type depression fears that we have been nursing over the last year, such an expression of good news would be cause for, well, a Mardi Gras type party right down the middle of Wall Street, or whichever street we happen to inhabit. But alas, a hike in the discount rate is technically a non event because banks only use the discount window in emergencies. The Fed Funds market is where most bank short-term lending and borrowing is done, and the Federal Reserve's news release is clear that the Fed Funds rate is not changing. Indeed, the most recent language from the Fed suggests that the Fed Funds rate is not likely to change anytime soon. But if the discount rate hike is completely unimportant, then why did the Fed go to the trouble of raising it? Call it the Fed's adherence to protocol. While the discount window is normally a place for emergency borrowing, it was a tool that the Fed used during the "valley of the shadow of death" when banks were so fearful of each other that they would not loan excess reserves to their brethren, even on an overnight basis. The Fed encouraged many big banks to borrow from the discount window as cover for banks who were being shut out of the Fed Funds market, as a result of loan losses and liquidity fears. The good news in the discount rate hike is the implication that the Federal Reserve now believes that the Fed Funds market has healed and that banks no longer fear each other's balance sheets the way they did a year ago. I think the Fed is merely giving cover to the banks that they encouraged to use the discount window to exit and return to the Fed Funds market. A true Fed rate hike would not be welcome news to most investors, but it would be to me. It would speak volumes about the nascent strength that is building in the US economy. We should all be hoping that a strengthening economy would force the Fed to move. The market won't like it for a day or two, but after what we have been through, it would be the surest sign that growth has taken root. Unfortunately, the Fed's action tonight doesn't carry that implication. But it does signal that the Fed Funds market has returned to normal, or close to it. That may be better news than most of us can understand.

Dividend Paying Stocks: The New Gold Standard

On one of the blackest days of the financial crisis in late 2008, I received a telephone call from a fellow investment manager. He is a person I respect very much and has built a great firm. He said he wanted to pick my brain on a matter that was urgent. He went on to explain that on that day he had $40 million in bonds coming due and the reinvestment options he was being given by his institutional brokers were all bad. Remarkably on that day he was being told that T-bills had a negative return. That is, he could put the money away in a safe place, but when it matured he would get back slightly less than he had put in. These were scary times. The man in question is a "Cool Hand Luke" kind of a guy and his voice was as steady as a rock as he went down the list of how bad things had gotten. The commercial paper market had frozen up; the corporate bond market was in a free fall; and stocks were collapsing. He said ordinarily he would just negotiate an overnight rate with a bank, but he had no idea which of the banks he dealt with were safe. Indeed, he wasn't even sure if his custodial bank where the assets were held was safe. His said he knew that I was a long-term investor and that I usually did not deal in the overnight market debt market, but he wanted to know what I felt "sure" about. What part of the financial system did I believe had the highest probability of making it through what looked like, at the time, an economy that was headed toward a 1929-type depression. I asked him if he was talking about stocks or bonds. He said both, but bonds first. I said the bonds I had the most confidence in were high quality municipal bonds. I added that I would stay away from the areas of the country that were having the most problems with real estate delinquencies. I went on to explain that municipal bonds had fared well during the 1930s depression, and I had a lot of confidence they could make it through this economic collapse, as well. He knew this as well as I did and concurred with my thinking. He asked about where I would invest in stocks. I think I surprised him when I said, "I believe one of the safest investments you can make in this market is what I will call "Gold Standard" common stocks. I told him that I thought there were approximately 100 companies in the world that might be safer than any government and would not only survive the crisis but would come out on the other side even stronger. I told him these companies would survive and prosper because of seven reasons:

1. They did business all over the world, so they were insulated from what was going on in the US or Europe.
2. They had a low debt to equity ratios.
3. They generated enough free cash flow to fund their working capital needs, so they did not need to be begging the banks for money. This free cash flow also gave them access to the capital markets.
4. They sold products that we use every day, what I call "essential services" products.
5. They were the undisputed leaders in their businesses, which allowed them to influence the competitive landscape for their whole business sector.
6. They had been around long enough to establish a powerful brand, and they were extending their brands in the developing countries of the world.
7. They treated their shareholders like owner-partners by paying a generous dividend.

I told my friend that these companies did not have the power to issue currency, nor field a standing army, but in an increasingly global economy, they had something better. They had created mutually beneficial relationships with billions of people the world over, who, on a daily basis, chose these "Gold Standard" companies' products and services more often than those of their competitors.

I concluded with the following. "I said I called these companies "Gold Standard" companies. I mean that literally in this way. Gold has long held the mystique, if not the reality, of being the ultimate store of value. Thus, in very difficult times when the financial system creaks and groans lots of money always goes into gold until the dust clears. But Gold's rate of return over very long periods of time has been poor, little better than inflation. The "Gold Standard" companies that I was thinking of had just as impressive a record of surviving the bad times, but had produced a compounded annual return that beat gold handily."

"Gold Standard" companies have been refined in the flames of countless tough economic times. Companies rise to the level of the "Gold Standard" not because they have survived for 25 to 50 years, but because they have grown for 25 to 50 years.

My conversation with my friend was now over a year ago, and while things have gotten better, there are still worries a plenty. But as I remind our clients often, "We are not investing in countries we are investing in companies. Companies that have been tested by time and have become more powerful because of the testing."