Wells Fargo is the third largest bank in the United States by share of domestic deposits with approximately 10% of the market.1 The banking industry is attractive because deposits, which are the raw material that lead to earnings, have grown every single year since 1948 and at a pace faster than GDP. Furthermore, contrary to popular belief, the banking industry has been profitable in 83 of the last 85 years. Large banks tend to be good businesses because, through deposits, they are able to borrow money at a low rate relative to their competitors, primarily non-bank corporations and smaller banks. This funding cost advantage occurs because 1) the government guarantees bank deposits up to $250,000 per account, 2) the industry is highly regulated, creating barriers to entry, 3) among banks, many customers value the liquidity, security, and convenience that the large banks provide over the higher interest rate they could earn if they deposited their money elsewhere, and 4) switching costs prevent most customers from constantly shopping and bouncing around for the highest deposit rates among the large banks. While this funding advantage is the most critical, it’s not the only advantage the large banks possess. After much consolidation in the industry, the large banks also possess superior geographic and product diversification that reduces the risk of their loan portfolio relative to more specialized lenders as well as economies-of-scale cost advantages in areas such as technology, cybersecurity, regulation, and marketing. For all these reasons, in addition to the much-improved balance sheets of both the banks and the average U.S. consumer post the financial crisis, we believe the large banks are likely to generate returns on equity that are significantly higher than their cost of capital over time. Finally, their business benefits from rising interest rates, so they may act as an interest rate hedge to the overall portfolio should rates surprise to the upside.
To read a more detailed description on WFC as discussed in a prior investment letter, click here.
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