Review & Outlook

Our take on the investing, financial, & economic themes of the day

Why We Sold Wells Fargo

19 October, 2016 by Matthew O'Brien, Ph.D. in Commentary

Below is an excerpt from our sell report for Wells Fargo.  Many commentators have missed the real significance of the bank scandal, we think, which is about managerial negligence and a weak commitment to its fiduciary obligations to the shareholder owners of the bank.  Wells Fargo’s management imposed unreasonable sales targets on employees and then failed to grasp the consequence, which was the widespread opening of fake accounts, even as management pocketed “performance” compensation for (falsely) reaching cross-selling goals.     

On September 8 enforcement actions against Wells Fargo was were made public by the Office of the Comptroller of the Currency, the Consumer Financial Protection Bureau and the Los Angeles City Attorney, which collectively fined the bank $185m.  The government agencies alleged that Wells Fargo engaged in “widespread illegal activity” and said that employees had opened as many as two million checking, savings and credit card accounts without customers’ knowledge.

Shortly after the announcement of the fine, the US Justice Department announced that it was in the early stages of investigating Wells Fargo for criminal and/or civil violations in relation to the illegal account openings.

According to the CFPB, the fraud didn’t just amount merely to opening fake accounts, but “[b]ank employees temporarily funded newly-opened accounts by transferring funds from consumers’ existing accounts in order to obtain financial compensation for meeting sales targets ” [emphasis added].

The magnitude of Wells Fargo’s fine is a pittance compared to the bank’s $22bn in net profit last year; similarly the 5,300 employees already fired due to the illegal account openings is small relative to the bank’s 200,000 workforce.  The political and regulatory blowback from the scandal could be more serious, however.  Most worrisome for shareholders are the defects that the scandal reveals in Wells’ corporate culture, its internal controls, and future business strategy.  The illicit account openings and money transfers raise a general question about the security of Wells Fargo’s accounts and its compliance with money laundering and ‘know your customer’ rules, and an abandonment of aggressive cross-selling practices would leave Wells without its signature business strategy of the past fifteen years, without a visible alternative.

Longtime sell-side bank analyst Dick Bove points out that if Wells employees opened half a million fraudulent credit card accounts to meet sales targets, then what does this say about the loan officers’ credit underwriting standards—not to mention the accuracy of management’s grasp of its loan book’s quality?

The response of Wells’ senior management to the scandal has been largely evasive and unconvincing both in its account of the origins of the illegal cross-selling and its purported remedies (see, e.g., Lucy Kellaway, “Wells Fargo’s wagonload of insincere regrets,” Financial Times, Monday 19 September 2016).

In April of 2016 Wells’ longtime head of retail banking, Carrie Tolstedt, announced her retirement.  At this time Wells knew of the regulatory investigations into its cross-selling practices.  Nevertheless, Tolstedt was feted by the bank at her retirement and received substantial additional stock options as compensation.  In the press release announcing her retirement, Wells CEO John Stumpf stated, “A trusted colleague and dear friend, Carrie Tolstedt has been one of our most valuable Wells Fargo leaders, a standard-bearer of our culture, a champion for our customers, and a role model for responsible, principled and inclusive leadership,”

Tolstedt worked at the bank for 27 years and headed its retail division since 2008.  Fortune magazine reports that

Tolstedt was regularly praised for her unit’s ability to get customers to open numerous accounts. For a number of years, Wells Fargo’s proxy statement, which details executive pay, cited high “cross-selling ratios” as a reason that Tolstedt had earned her roughly $9 million in annual pay. For instance, in Wells Fargo’s 2015 proxy statement, the company said that its compensation committee had authorized Tolstedt’s $7.3 million stock and cash bonus that year, because “under her leadership, Community Banking achieved a number of strategic objectives, including continued strong cross-sell ratios, record deposit levels, and continued success of mobile banking initiatives” (Stephen Gandel, Fortune, “Wells Fargo Exec Who Headed Phony Accounts Unit Collected $125 Million” September 19, 2016).

Tolstedt’s performance compensation for achieving inflated and partially fraudulent cross-selling numbers suggests that senior management is better at running the bank to reward themselves, rather than the bank’s shareholder owners.

John Stumpf will testify before the US Senate this week in order to answer questions about the scandal; Stumpf already has refused to identify any senior executives who are responsible for the individual “bankers, managers and managers of managers” to whom the bank has attributed blame, and he refused to name the most senior employee let go thus far.

According to the Journal, Wells’ dedicated focus on cross-selling banking products to Mainstreet customers dates to the late 1980s when then-CEO Richard Kovacevich brought the strategy from the acquired bank Norwest Corp.  In 1999 the bank reported that its retail customers on average held three accounts and that it hoped to increase that number to eight.  This program was known internally to employees as the “Gr-eight” initiative; Kovacevich picked eight as a target because it rhymed with “great.”

Currently Wells reports that its average Mainstreet customer owns over 6 products from the bank.  Not only does this figure trounce the industry average, but Wells, unlike other banks, reports this figure explicitly in its quarterly earnings.

Some analysts have compared the Wells scandal to JP Morgan’s “London Whale trade,” which resulted in huge losses and fines over the bank’s failure to oversee its derivative trading risk, but ultimately proved navigable for Morgan.  But the Wells’ scandal seems more serious, because it cuts to the heart of Wells’ carefully crafted image as the plainspoken, ethical alternative to rapacious Wall Street banking.  At Morgan, by contrast, everyone knew that the bank had a big, aggressive, and lucrative tradition operation, which was one reason why you owned it.  If Wells’ corrects the incentives and culture that led to the problem, then it will presumably have to give up its marquee business strategy.

Regulators will now probably scrutinize all retail banks, whereas previously they had focused upon those banks with rarified trading and securitization practices that are far removed from the ordinary public’s everyday concerns.

Wells pays a handsome +3% dividend yield, which is safe and sustainable, due to its relatively low payout ratio of about 36%.  This fact alone will probably lead many shareholders to ignore the scandal and hold on to the stock, or even to buy its recent sell-off.

Nevertheless, on balance the uncertainty about Wells’ future retail strategy, risks of further regulatory and criminal action, and an apparently dysfunctional corporate culture coupled with managerial negligence makes selling more reasonable.

Twenty years from now, would you rather be paid in euros or pounds?

17 October, 2016 by Matthew O'Brien, Ph.D. in Commentary

I asked myself this question as I read the commentary about the recent sell-off in the pound sterling.  Here is the pound against the dollar:


Many commentators have taken the opportunity of the sell-off to castigate Brexit and Britain’s new prime minister, who seems bent on implementing the results of the referendum and not slowly walking it back.  Thus Martin Wolf, the leading economic mandarin at the Financial Timespronounced that the sell-off was the market’s verdict on Brexit’s foolishness.  Yet it seems much more foolish to me to divine in short-term currency fluctuations any judgements about sovereignty.  Let’s also remember that the Bank of England’s policy response to Brexit has been to weaken the pound, so it’s hard to argue that a weakening pound is itself somehow clearly attributable to Brexit alone.  In any case, if today you gave me an annuity that started paying twenty years from now — choosing either in pounds or euros — I wouldn’t hesitate in choosing pounds.  So too, presumably, would some of the founders of the euro.

Professed Sentiment vs. Deliberate Action: What Investors Say Often Isn’t What They Do

13 October, 2016 by Mark O'Brien in Commentary

In the mid-1980s I noticed that many portfolio managers, like myself, said they were bullish but were not managing their portfolios that way.  That’s because the previous ten years or so had been so bad that one just could not imagine they were really over.  Thus portfolio managers and other investors said one thing while doing another.  You can understand why. When I graduated from college in 1973, the Dow broke 1,000 for the first time.  Ten years later, the Dow was 740, and this did not include an adjustment for inflation, which was horrible in the period.

Now I notice that portfolio managers and other investors say they are bearish about stocks. In the often backwards and upside down world of stock investing, such bearish sentiment is often taken as a positive.  How’s that?  If investors are already negative, they cannot turn that way.  So, presto, bad is good. But are portfolio managers really acting out of bearish sentiment right now?  I’m not so sure. It could be the mirror image of the mid-1980s phenomenon. That’s because the last 25 or so years have been so good for stock investing that people don’t really believe they could be over.  Just in the last seven years stocks are up almost 200%.  Any paring back of stocks has been punished with bad stock performance.  The human inclination is to drag your feet and wait for more confirmation.

The lesson is to take sentiment indicators with a large grain of salt, because they may indicate what people are thinking and saying at the current time, but not what they are doing.

Reflecting on the Culture of Investing

11 October, 2016 by Mark O'Brien in Commentary


The occasion was a luncheon in the mid-1980’s at the Union League Club of Philadelphia, followed with a talk by Sir John Templeton, the great investor and benefactor.  After a short talk, Sir John took questions, the first of which was his best investment idea for making money.

I was a member of the audience and can say that I was sorely disappointed in the answer, for I was then a young man in a hurry, newly out on my own as a money manager, and hungry for investment ideas that would make money—preferably a lot of money—for my clients, and thereby help me attract new clients and build a larger investment-advisory business.

“My best investment idea for making money?” replied Sir John.  He paused.  He surveyed the room.  He took more time.  The luncheon guests shifted in their chairs, pens at the ready, the air crackling with anticipation.  Sir John looked into the faces of those present, studied them, and after a long time said, “My best investment idea for you, for each of you, is to tithe.”

To say the air went out of the room would be an understatement.  I can confidently say that most of those present were not familiar with the word, much less with the ancient practice of each year giving a tenth of one’s income to charity.

Sir John went on to answer other questions in a more conventional manner, responding with comments on then-current and likely future interest rates, the prospect of inflation, trends in employment, and other measures regularly considered in the trade of investing.  Many years later, however, and nearing the end of a long investing career, I return to Sir John’s answer.  He was clearly on to something that we as individuals and as a society forget at our peril: that investing is, first, an act of culture.  Habits and practices, shared understandings of ethics and morality, must be in place before people will be persuaded to give up something today in return for the prospect of even more tomorrow.  Ownership of private property and the rule of law are often cited as preconditions, but no less important are personal qualities (or are they virtues?) of trust, patience, hard work, enterprise, thoroughness, consistency, the need for planning, and resistance to believing in fables–like getting rich quick.

The conclusion is that managing a portfolio of stocks and bonds is often the easy part.  More difficult, and always more important, is the process of learning how to recognize and then adopt the habits of mind–the culture if you will–in which successful investing can take place.

Practicing Patience With the Market at an All-Time High

28 July, 2016 by Ben O'Brien in Commentary

Recently the financial press trumpeted that the S&P 500 was at a new “all-time high.” In one sense this is a good thing, a sign of strength and resilience, that the market has recovered from the financial crisis and is breaking new ground. In another sense though, many stocks are getting expensive and bargains are harder to come by than they have been in a while.

In markets like these, patience is key. Seeking out reasonably priced, high-quality stocks is essential because you can’t rely so much on market wide “multiple expansion” which is the rising tide that sometimes lifts all boats.

Warren Buffett has said that success in investing is as much or more about temperament than it is about intelligence or expertise. In today’s uncertain market, we believe avoiding panic and cultivating virtues like patience and discipline is of more use than the financial or mathematical jujitsu practiced by Wall Street super geniuses.

Buffett’s right hand man, Charlie Munger once said, discussing the record of Berkshire Hathaway: “If you took our top fifteen decisions out, we’d have a pretty average record. It wasn’t hyperactivity, but a hell of a lot of patience. You stuck to your principles and when opportunities came along you pounced on them with vigor.”

Patience has been on my mind a lot recently. I am waiting for a number of things, not least for my first child to arrive, due on September 10th. Reading a book about parenting I learned that, according to one school of thought at least, cultivating patience in a child from the very beginning provides the underpinning of everything in his or her development from sleep to eating to communication. The book cites a famous study at Stanford in the 1960’s and 70’s where three-year-olds are given a marshmallow and told if they don’t eat it until the adult comes back in a few minutes, they will get another one. Most kids can’t resist. They eat the marshmallow almost immediately. But for the ones who don’t, this display of patience is correlated with all sorts of success in life later on.

Forgoing present gratification for the sake of much greater benefits later is what investing is all about. A recent column by the economist and blogger Tyler Cowan highlighted the larger crisis of impatience in American society. He argued that the discontent among large portions of the electorate today is linked to the retirement crisis and lowered living standard that has resulted from the sharp decline in the saving rate over the last 30 years. This impatience, Cowan notes, is just as much present is public sector—unfunded pensions, fiscal deficits, etc.—as it is in households.  As a society we have spent several decades eating the marshmallow.


Source: Bloomberg

The study mentioned above found that the children who successfully passed the test were the ones who found some way to distract themselves, twiddling their thumbs or playing a little game. Those who stared at the marshmallow invariably ate it. At O’Brien Greene our way of distracting ourselves from the irrational mood swings of the market is to spend a lot of time on the analysis of individual stocks. We try to understand each business, its management and its industry and evaluate its future cash flows as well as the durability of competitive advantage.

If you really know your stocks, it’s easier to hold on when the market and the media are seized by fear. You know that even in the worst of times people will still do Google searches or drink Coke, and so companies that make these essential products will continue to generate strong cash flow.

I met a guy recently who works at a successful Buffett-style investment firm where he says some research analysts will go for a whole year without recommending a single trade. Some people find it boring, but their performance is very good. The key is during this period of apparent inactivity you need to be actually building up a base of knowledge and an extensive watch list so that you can decisively spring into action when the opportunity finally arises.

When it comes to investing, patience pays. Don’t eat the marshmallow!