Wells Fargo preferred stock is one of my favorite banks that has issued preferred stock because: (1) Wells Fargo preferred stock is backed by outstanding bank fundamentals; (2) Wells Fargo preferred stock continued to get paid during the financial crisis on all classifications of preferred stock; and (3) the value of the Wells Fargo preferred stock generally trades close to fair value of the listing.
That third element may surprise you, as you might intuitively think that Wells Fargo preferred stock might be subject to the same “flight to quality” overvaluation syndrome that hits the common stock equity markets. Usually, in the preferred stock markets, it is the junk yielding north of 10% that is the most subject to overvaluation.
This isn’t intuitively obvious, but I’ll see if I can explain. Remember a year or so ago when we talked about how some of the biggest bubbles in the student loan market is for those facing six-figure student loan debt? The reason why it is improperly priced is because, at a certain level, it no longer feels like real money. Is there a big difference between a bank lending a student $75,000 for a medical degree instead of $95,000? If you’re the student borrowing, can you quantify the difference between $75,000 in student loan debt compared to $95,000? No, it feels mostly theoretical at that point, in the difference in $10,000 gradations doesn’t feel real once you get close to that six-figure mark.
Well, something similar plays out in the valuations of preferred stock listings. When you consider purchasing a junk preferred stock listing from a poorly capitalized oil driller, it is difficult to ascertain whether the proper yield should be 14%, 16%, 18%, or 20%. Once you enter the realm of high-yield preferred stocks, the discipline in the valuation starts to disappear a little bit because it’s harder to be finely attuned to fair value: How do you know whether to insist on 14% or 16%? Finding that walkaway point is much harder when a security has inherently speculative characteristics. That’s why it’s not unusual to see things that should be yielding 15% instead yield 11%–both feel like a lot of money coming your way if the firm survives, so the attention to nuance becomes unfocused.
But because Wells Fargo preferred stock typically yields 5% or 6%, there isn’t much opportunity for preferred stock investors to bid the preferred stock to unreasonable levels–if Wells Fargo preferred stock traded at a 3% or 4% yield, investors could just buy something like a Treasury bond or high quality common stock that yields just as much. The competition gets intense at the 3% to 4% yield range, acting as an important alternative that prevents investors from overpaying for Wells Fargo preferred stock.
Out of the dozens of Wells Fargo preferred stock listings, my favorite is WFC.PRQ, or the Wells Fargo & Co. 5.85% Fixed-to-Floating Rate Non-Cumulative Perpetual Class A Preferred Stock, Class Q.
It has a $25 liquidation preference with a call date of September 15th, 2023, and only trades at $25.38. The terms are interesting: You collecting $0.36563 on March 15th, June 15th, September 15th, and December 15th through June 15th, 2023, and from the September 15th call date onwards, if the bond isn’t liquidated by Wells Fargo for $25 each at that point, you will then collect an annual rate equal to the three-month LIBOR plus 3.09%.
That readjustment is a very important. The main risk for investors of Wells Fargo preferred stock is rising interest rates. For lower quality companies, the risk is equally: (1) rising interest rates and (2) the failure risk of the company. With Wells Fargo, the failure risk is remote as possible–even back in 2009, the company was still making $12 billion per year in profits but had to cut the quarterly dividend to a nickel to appease the Fed (though temporary impairments did bring 2008 profits down to $2.6 billion from the 2007 level of $8 billion). Even with the common stock dividend at a nickel, the preferred stockholders still got paid. And now, Wells Fargo makes over $21 billion per year in annual profits.
Over the past thirty years, there haven’t been many perpetual preferred stock listings that have lived up to the name because it has made economic sense for the company to liquidate the preferred stock and then issue new preferred stock at a lower interest rate. With interest rates in a long-term downtrend, it made sense to cancel out the old obligations and then start over on more favorable terms with lower interest rates.
The 2016 onward period is going to look much different. When interest rates rise, the old obligations will look good. If the Fed raises rates two and a half points, and future Wells Fargo preferred stock offerings have to be issued at seven percent or greater, then it won’t make economic sense for Wells Fargo to liquidate the preferred stock on the call date. Although there are difficult to find, this means that you want to look for preferred stock that has some sort of eventual readjustment if interest rates march higher over the coming five to ten years.
The Wells Fargo preferred stock Series Q (WFC.PRQ) offers precisely that. In 2023, you will get a Libor readjustment plus 3.09%. The terms are great for Wells Fargo because: (1) if interest rates rise significantly, Libor plus 3.09% is still less than the cost of a fresh listing in 2023; (2) if the terms aren’t less than the cost of a fresh listing, then Wells Fargo can liquidate the Wells Fargo preferred stock at $25; (3) if interest rates manage to stay lower than expectations, then Wells Fargo will lower its costs further by only having to pay 3% or 4% on this 5.85% security.
So, if the deal works out well for Wells Fargo in all three scenarios, why is this my favorite Wells Fargo preferred stock? Because the terms are still better than the other preferred listings, which allow Wells Fargo to get locked in at 4% or 5%. Without the readjustment, Wells Fargo can just continue indefinitely paying out 4% or 5% on many of the Wells Fargo preferred stock offerings leaving the preferred stockholders stuck in a suboptimal allocation trap–do you continue to take 4% indefinitely, or sell the preferred stock at a lower price that reflects the higher interest rate environment?
The only scenario in which the Wells Fargo preferred stock Series Q is not better than the alternatives is if interest rates remain low through 2023. In that scenario, the Libor readjustment would penalize you by forcing you to collect a lower amount of preferred dividends. I consider that possibility remote, but it’s still a risk that exists.
Between now and the final payment that precedes the September 15, 2023 Libor readjustment and call date, Wells Fargo preferred stockholders in the Series Q offering (WFC.PRQ) stand to collect thirty payments of $0.36563 payable on the fifteenth of March, June, September, and December of each year. You stand to collect $10.97 through the summer of 2023, plus you would get a $25 share liquidation. You’d collect around 43% of your initial investment over the next seven years through this Wells Fargo preferred stock investment. Your total returns would be about 42% minus taxes due to the current 1.52% premium over liquidation value for the preferred stock.
Although this is the best of the Wells Fargo preferred stock offerings, I would not recommend buying this now. In the entire world, Wells Fargo common stock is probably one of the top 100 best common stocks that can be purchased for the long term based on the present known risk factors of the 50,000 publicly traded common stocks in existence around the globe. It has compounded at 14% annually since 1972. Even if you bought Wells Fargo right before the financial crisis started, and purchased at the relative highs of 2007, you still would have compounded your wealth at over 6% through today. Think about that: Common stockholders on the eve of crisis would have collected returns that are superior to what you’d collect in aggregate through this Wells Fargo preferred stock listing.
Since 1991, this stock has compounded at 14% annualized to turn a $10,000 investment into $260,000. The twenty-five year dividend growth rate of the common stock is over 11%. The current common stock dividend is $1.50. There is a high probability that, come the summer of 2023, the Wells Fargo common stockholders will be collecting over $3 per share, or double the current yield and surpassing the annual income that you would get from this preferred stock offering.
If interest rates rise, the amount of gains for Wells Fargo’s net income will be far better than anything you’d get from a Libor readjustment when the autumn of 2023 approaches. The Wells Fargo common shareholders will probably add more than 100% to their wealth between now and 2023, while the Series Q holders of Wells Fargo preferred stock will be looking at a total gain of near 42%. While the series Q offering of Wells Fargo preferred stock is the best of the current Wells Fargo offerings, it will almost certainly be dwarfed by the long-term performance of Wells Fargo common stock.
The Wells Fargo preferred stock Series Q is attractive on a relative to basis to other preferred stock listings in the bank sector of similar quality, but it is very unattractive on an absolute basis compared to the risk-adjusted profit potential inherent in the common stock. Reaching for an extra two points of yield will have significant opportunity cost drawbacks to the common stock, and you should address this high opportunity cost before considering any of the Wells Fargo preferred stock offerings.
Originally posted 2016-02-22 19:27:53.