Morningstar - Q3 2021 - 83

improving. So, you don't see a lot of the danger
signs that you saw in the past.
The one sign that is a little worrisome is
housing price appreciation. It looks higher than
normal, and this rate of increase doesn't
seem sustainable. I think there will be some
buyer's remorse, but it's not going to be on the
scale that we saw before.
Lallos: You wrote that in 2020, valuations were
about credit and that today, it's more about net
interest income.
Compton: The big question in 2020 was,
is credit and capital going to be fine? We've
answered that question and valuations
have recovered to some degree. Now it's
a question of how much banks will thrive after
the pandemic.
Obviously, economic activity is going to play
a role in growth in fee income and loans and such.
But the biggest driver is going to be interest
rates, because most banks have 50% or more of
their income coming from net interest income,
which is directly tied to interest rates. If you
get a better interest-rate environment, half or more
of your revenue is going to go up, without
any additional costs. It's almost a 100% margin
type of improvement in revenue.
Rates are really the biggest driver going forward,
and that's the biggest question that investors
need to think about when they're thinking about
investing in banks. Conceptually, yes, a lot
of things are looking good for banks. But what are
you paying for-are you OK with the assumptions
that you're making? I'll be the first to admit
I cannot predict with great precision where exactly
rates will go and when. But what I can tell
you is on average what you are likely paying for,
and I think today people are paying for a fairly
positive interest-rate thesis.
Lallos: You believe that prices today are accounting
for about 200 basis points of rate hikes. But the
way that Morningstar values stocks, the timing of the
rate hikes doesn't matter so much, because you're
looking at such a long time horizon.
Compton: Yes, as long as you get the overall
picture right, it doesn't matter too much if you get
it right today or tomorrow. The full life of the
company is where most of the cash flows take
place. If you're off by a year or two as far
as the timing of that step up in cash flows, in the
grand scheme of things, that makes a 1%
or 2% difference on average per year for most
of the banks under my coverage.
You still are subject to the timing of the market.
You might be right as far as the overall picture, but
you may have to wait a couple years before
the market starts to price it in. Theoretically, that
shouldn't matter too much if everyone's
investing for the long term. But I get it. You'd
rather see things go up sooner rather than later.
Lallos: You noted in your report that bank valuations
are not as tightly linked to yield curve steepness
as people think.
Compton: You hear a lot that the yield curve
steepening is good for banks. But you have to get
past such one-liners, because that's not
always the case. Yield curve steepness is a
function of both the short end and the long end
of the curve, so you can get steeper by dropping
the short end or by raising the long end.
And oftentimes, what's happening on the short
end is much more relevant, not only because
it tends to have a larger absolute impact on the
banks, but because it's a sign of what the
Fed is up to: If the Fed's cutting rates, that is
usually a sign the Fed is worried about an
economic slowdown or something of that nature.
If the yield curve is steepening as the result
of economic strength, that is a net positive for the
banks. But then how much is that actually
going to affect bank profitability, and how much
of that is already priced in?
Lallos: Banks will be allowed to do share buybacks
again later this year. Are there some stocks that will
benefit more than others?
Compton: Everyone will benefit to a degree.
There's a lot of excess capital in the system. Banks
haven't been able to buy back shares during
the pandemic, so there's pent-up capacity. After
the Fed stress tests, they should go back to normal.
They will be free to spend excess capital as
they please, as long as they satisfy the capital
requirements.
One name that has stuck out for us has been
Wells Fargo WFC. We think they have a
lot of buyback capacity. They aren't the most
profitable. Their returns still aren't the best.
They're still working through a lot of issues on
regulatory expenses. And they are fairly
rate-sensitive, so that's hurt their profits a little bit
more than peers. But they also have a ton
of excess capital. We don't think it's unrealistic
that Wells could repurchase 10% or more of
its shares over the next year.
Capital One COF is another name that has a
lot of excess capital, enough where we wouldn't
be surprised to see the bank be able to
buy back 10% or more of shares over the next
12 months. A lot of the other banks should
still be able to repurchase shares, just not quite as
much, probably closer to a 5%-10% range
over the next year based on excess capital and
how much we expect them to earn. In general,
it's a sectorwide story: Buybacks are coming
back, and shareholders who stick around will own
a larger percentage of the company.
Lallos: Wells Fargo seems to be a turnaround story.
What's going right?
Compton: Wells Fargo has been in regulatory
purgatory, especially as it relates to the asset cap,
which is probably the biggest regulatory item on
most investors' minds. With the asset cap,
Wells Fargo is not allowed to grow the balance
sheet. Putting a cap on the balance sheet puts a
cap on loan growth, and it's also a reputational
stain that stays with the company.
A big part of the turnaround is getting the
asset cap removed. They've been working on that
for over three years now, and regulators
reportedly signaled in February that they had
internally approved the plans that Wells
put forward. That was the first time that there had
been any sign of progress with the regulators.
That's part of the turnaround. We now expect the
asset cap to be removed in Q4 of this year
or Q1 of 2022, which would finally put an end to
what has been a multiyear saga. It seems
like they're making some progress, and I think
that's one reason why shares have traded
up and they aren't quite at the discount they used
to be.
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Morningstar - Q3 2021

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