Could Buffett's Favorite Bank Stock Skyrocket From This $100 Billion Bet?

David Sterman's picture

Friday, September 5, 2014 - 5:00pm

by David Sterman

A little-noticed milestone took place in the just-completed earnings season. After 17 straight quarters of sequentially stronger earnings, banking giant Wells Fargo & Co. (NYSE: WFC) saw its per share profits fall a few pennies.

It’s safe to say that all of the margin gains that have been delivered from streamlining after the 2008 financial crisis have been wrung out. The top line isn’t looking much brighter: Wells Fargo is expected to boost revenue by less than 1% this year.

To get the top and bottom line moving higher, Wells Fargo announced a bold move: It aims to spend $100 billion to acquire niche financial service firms, known as asset managers. These are mutual fund firms, operators of exchange-traded funds (ETFs), retirement plan sponsors and pension management firms, which as a group hold trillions in Assets Under Management (AUM).

Indeed, you can expect to hear a lot more of the term AUM in coming years, as Wells Fargo is likely just the first of several major banks that want to build up their asset base.

Why AUM, and why now?

In recent years, partially due to the Dodd-Frank Act passed in 2010, banks have narrowed their focus and exited seemingly risky businesses such as proprietary trading. Regulators want to be sure that in the next economic downturn, banks don’t topple so quickly and threaten the entire financial foundation of the country. As a result, banks, like Wells Fargo, are in search of lower-risk lines of business, yet they still want to garner strong returns on their equity base.

Asset management is the perfect solution. It’s a business with a sticky customer base, it’s capable of generating strong fee income and, more importantly, it can generate a significant amount of interest income on any clients’ un-invested cash. Such interest income is low right now, but will steadily rise as interest rates do.

In this industry, you’re talking about some large numbers. By spending $100 billion, Wells Fargo could acquire hundreds of billions in AUM, instantly making it a force in the fund management industry.

The bank could look to target mutual fund firms -- mutual funds are the most popular type of fund with $15 trillion in AUM, according to the Investment Company Institute (ICI). The top five mutual fund families control 40% of that asset base, or $6 trillion, according to the ICI. The numbers start to blur a bit when you consider that the top mutual funds have also begun to make a big push into ETFs. (Check out the nation’s largest fund managers.) 

Yet, Wells Fargo is likely to conclude what many other investors are now realizing: mutual funds are no longer worth the high fees they charge.

Even funds that do deliver a solid performance and justify their high fees are at risk of losing a well-regarded fund manager.  In Wall Street parlance, when key talent decides to leave, it’s known as “assets walking out the door,” because investors often follow suit.

Also, investors appear to be losing interest in the mutual funds currently operated by Wells Fargo.

Instead, Wells Fargo may look to focus on the ETF firms, which are surely a growth category and are not dependent on the star power of key fund managers. The AUM at ETFs is growing by more than $200 billion a year, and now stands at more than $1.7 trillion, according to ETFtrends.com. Sure that’s a fraction of the AUM at mutual funds, but the gap is slowly closing.

Invest with the Best?

At first blush, BlackRock (NYSE: BLK) would be a great target for Wells Fargo. With more than $600 billion in AUM, Its iShares ETF program is the largest—by a considerable margin. Trouble is, BlackRock is already worth $55 billion, and would likely fetch $70 billion in a buyout offer. It would be hard for Wells Fargo to justify the deal to investors, considering BlackRock generates just $1.5 to $2.0 billion in annual free cash flow.

With a market value of around $30 billion, State Street (NYSE: STT), which runs the venerable SPDR ETFs platform is a more digestible acquisition, and with its wide range of other back-office financial services skills, could help Wells Fargo move into new niches.

Yet the most appealing buyout target for Wells Fargo may just be WisdomTree Investments (Nasdaq: WETF). (Full disclosure: I was the Director of Research at a predecessor company to Wisdom Tree).  WisdomTree has just $35.5 billion in AUM, less than a tenth of the size of BlackRock, but it has proven to be a savvy marketer of unusual niche ETFs. WETF’s growth has been impressive: AUM stood at less than $20 billion in 2012, but should exceed $55 billion by 2016, according to Merrill Lynch, who has a $14 price target.

Shares stood at around $18 when the year began, but a modest outflow of AUM in the first quarter has weakened shares (though AUM growth rebounded into the black in the second quarter).

Smaller, more digestable acquisitions for Wells Fargo may include:
•    Cohen & Steers (NYSE: CNS)
•    Janus Capital (NYSE: JNS)
•    Federated Investors (NYSE: FII)
•    Affiliated Managers Group (NYSE: AFG)
•    Legg Mason (NYSE: LM)
•    Invesco (NYSE: IVZ)
•    T. Rowe Price (Nasdaq: TROW)

Risks to Consider: When one financial services firm acquires another, there is always a higher-than-average risk that key talent in the acquisition will decide to leave. Moreover, any acquisitions in this niche could dilute per share profits in the near-term, which can scare off some investors.

Action to Take--> Wells Fargo’s foray into asset management makes ample sense, as it represents a complementary set of services to offer its existing customer base.  The fact that the bank is also well-positioned for an eventual upturn in demand for mortgages is just another arrow in this company’s quiver.

Wells Fargo would be a possible candidate for “Forever” stock status. A Forever stock is designated as a company that is so stable and profitable that you could literally buy shares and hold them for eternity. These world-dominating companies control deep economic moats allowing them to fend off competitors. For more information on Forever stocks, click here.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.