I am comfortable with credit quality at our community banks despite sluggish overall growth and pronounced weakness in the energy market. Energy is not an area of significant exposure for our community banks but the issue bears watching, particularly for signs of any spill over into other assets.
We have not sold any of the four investments we made last year – including CBNJ which, as previously discussed, is merging with OCFC later this year – although my guess is that one or more may be sold in 2016. We also made one new investment in a bank completing its conversion during the first quarter, shown at the bottom of the following table:
In January, we made a new investment in Wells Fargo’s TARP warrants. These warrants were created in the wake of the 2008 financial crisis when the government required WFC to participate in the recapitalization of the banking industry. (Wells Fargo had plenty of capital, and it even remained profitable through the crisis, but all large U.S. banks were forced to take money from the Troubled Asset Relief Program.) The warrants were subsequently auctioned to the public and listed on the New York Stock Exchange. They expire in October 2018 and the strike is currently $33.896. The strike will adjust downward according to a formula based on the prevailing market price and each quarterly dividend payment that is greater than $0.34 per share. The most recent quarterly dividend was $0.375, and I estimate the strike at expiry will be approximately $33.50 or slightly lower, although that is based on several estimates that are subject to change. In any case, there is fairly little premium in the warrants given the recent market price of the warrants near $15.00 and WFC’s common stock between $45 and $50. In fact, many of our warrant purchases were made at a price that would have afforded an immediate profit of five or 10 cents per warrant had we exercised immediately. But if we hold our investment I think the outlook is far better.
In my view, Wells Fargo is an excellent business. The current worries about interest rates and energy losses are well founded, but I believe the strength of the company’s franchise and balance sheet will prevail over a period of years. I think the evidence shows that Wells Fargo is one of the best-managed banks in the world, with ample reserves and capital to withstand the coming challenges. Its energy loan book of roughly $20 billion, for example, was ramped up in the past few years. That was obviously the wrong time to expand, but energy still comprises less than 2% of its total loans and the company has already booked loss reserves approaching $2 billion dollars. Substantially all of the currently non-performing energy loans are senior secured, and ~90% of them are still current on interest and principal. Reserves and losses are almost certain to go materially higher and I think another billion – or possibly a few billion – in losses is probable. Nonetheless, Wells Fargo is still likely to earn pre-tax profits of more than $30 billion per year during that time.
With a massive, low-cost deposit gathering franchise, a conservative credit culture, and excellent management, there is a lot to like. A sustained period of negative interest rates in the U.S. is a meaningful risk, but I believe the odds are favorable for now. Likely due to those worries, the stock has declined and the valuation is reasonable at less than 12 times earnings (less than eight times pre-tax earnings) and roughly 1.7 times tangible book value. If the earnings trajectory is merely stable and the current capital allocation policies are maintained, I believe book value per share is likely to compound at 6-8% per year for the next few years. If so, the return on our warrants should be quite good. If the stock stays flat – i.e., if the price is still at $48 in October 2018 – we could make a little bit of money. If the stock declines we are exposed to loss just as we would be in any investment, but given the valuation, the 2 ½ years to expiration and the quality of the business, I believe this is a favorable opportunity and a good use of our capital.
The above commentary is excerpted from the 1Q16 quarterly letter of Anabatic Investment Partners LLC. The fund’s Managing Principal and Portfolio Manager is Philip C. Ordway. Please note that the complete text of the disclaimer included with the fund’s quarterly letter is also reproduced below.
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