Wells Fargo’s earnings, why markets are loving the stock

The SPDR S&P 500 ETF Trust (NYSEARCA:SPY) has been trading within a tight channel during the past year, hovering between the $420 and $375 per share marks. This trading range could be seen as ‘indecision’ from broader market participants, and only ‘directional’ data can bring certainty for these same participants to push the market above or below the range.

Key points

• Wells Fargo posted second quarter 2023 earnings results, pointing to a superior position as shown by its rising stock price relative to peers. 

• Significant NII growth is pushed by the foundation laid by the business model itself. This trend could continue now that the underlying economy favors the consumer rather than the business cycle. 

• Markets reward the stock with higher perceived valuations, especially around expected earnings. Expanding fundamentals and building momentum may push the stock out of the previous trading range.

• 5 stocks we like better than Citigroup.

As banking earnings kick off this summer, they can act as a reasonably reliable gauge of where consumers and businesses are in the business cycle. This is a critical metric today, considering the U.S. economy is pivoting hard due to the interest rate hikes in the FED.

Wells Fargo (NYSE: WFC) is one of the banks that passed the annual FED ‘stress test,’ which consequently enabled management to boost the dividend payout for shareholders. Today, the bank is one of the diversified banks reporting second-quarter 2023 earnings results, and markets are jumping all over the stock.

On a day when banks like Bank of America (NYSE: BAC) and Citigroup (NYSE: C) are seeing their stock prices fall, Wells Fargo is proving to be the maverick by rising as much as 5% during Friday’s trading session. For other reasons that will become obvious to investors, Wells Fargo is the favored stock in the diversified bank peer group.

The difference maker

Net revenues for the bank rose by as much as 20% during the year, an astonishing feat considering that most other banks are expected to post declines. The secret sauce for Wells Fargo lies in its business composition; the bank focuses more on consumer banking and products rather than investment banking activity.

Banks like Citigroup are seeing double-digit declines in investment banking revenue due to a slowing business and credit cycle, severely affecting net earnings for such names. 

Conversely, NII (Net Interest Income) for Wells Fargo considerably drove the bank’s results. A 29% annual advance in NII was only made possible through the bank’s focus on the consumer side, generating significant income from loans and deposits.

Loans rose by $19 billion over the year, driven by commercial loans and consumer credit cards, one of the drivers pushing NII higher. The second leg supporting the 29% advance comes from rates themselves; as the FED raises the national interest rate, banks like Wells Fargo can now generate more income on loans like mortgages and credit cards.

Wells Fargo analyst ratings point to a consensus upside potential of 11.3% from today’s prices. A decent double-digit potential upside is acceptable. However, investors may find a solid reason to expect a higher payout.

Based on the current market’s ‘voting system,’ broken down via forward price-to-earnings ratios, investors can begin to gauge which stocks are rewarded with higher perceived values regarding future expected earnings. Today’s rise in the stock price, and superior financial results, are only a prelude to the real differentiator against peers as laid out by the broader market.

Rewarding valuations, potential risks

Wells Fargo trades at a 9.1x forward P/E, relatively superior to other names like Citigroup and Bank of America, which trade at a 7.7x and 9.0x, respectively. Some investors accustomed to picking the best stocks for the lowest price as a premise for a value investment may feel uncomfortable paying a higher valuation relative to the group.

However, this ‘forward’ valuation can be taken as a subtle hint from markets; this willingness to overpay for each dollar of future expected earnings directly translates into higher perceived quality.

This higher perceived quality comes from the underlying earnings drivers. As Wells Fargo carries a superior exposure to the consumer rather than the business cycle, markets may be placing their bets on where the stock may end up going. One angle investors should watch out for when weighing potential risks is the provision for credit losses within the bank.

A $1.7 billion provision was reported for the quarter, representing a significant reserve involving office-building loans. As remote work trends draw people out of office buildings, potential losses in this department may cause some concern.

Now that markets have digested a magnificent 68% increase in annual earnings per share, the stock may find enough traction to break out of its recent ranges. Like the S&P 500, markets have been indecisive toward Wells Fargo stock. However, favoritism trickling through via valuations and improving fundamentals may act as the needed push to break out of previous ranges.