If there is one thing I have learned about investing in stocks, it is to expect the unexpected.
Life is filled with uncertainty and surprises, and companies in our investment portfolios are no different.
I steer clear of most investment opportunities because they are outside of my (limited) circle of competence.
For this reason, I largely avoid the financial sector because I have no good way of understanding the quality of loans on a bank’s balance sheet or an insurer’s level of underwriting risk.
Given the opaque nature of most financial firms’ financial statements, any investment requires a lot of trust in the management team to appropriately price and manage risk.
Financial leverage used by banks and insurance companies cuts both ways and can be absolutely disastrous when management gets risk wrong (surely no one will ever forget the financial crisis).
Wells Fargo (WFC) is one of the only bank stocks I have been comfortable enough to invest in. I outlined my full thesis on the business here.
I liked Wells Fargo because of its stellar reputation for managing risk, conservative business model (for a bank), and cost advantages stemming from its large base of deposits.
However, Wells Fargo’s reputation has come under pressure over the last week in light of the bank’s illegal actions to open unauthorized customer accounts.
What Did Wells Fargo Do Wrong?
Wells Fargo employees opened over 2 million deposit and credit card accounts that may not have been authorized by customers over the last five years. The company gained $2.6 million in fees from the fraud and was fined $185 million by regulators.
Wells Fargo is known for its cross-selling practices. The company tracks its retail products sold per household in its annual reports, and it clearly maintained an overly-aggressive incentive policy that encouraged many branch employees to break the rules.
Fraudulent activity is inexcusable. The difficult judgment call that needs to be made now is how systemic this issue is across the entire company. As long-term investors, the last thing we want to do is invest our capital with management teams lacking ethics.
At the end of 2015, Wells Fargo had 264,700 active employees including around 100,000 employees in its retail branches.
The 5,300 employees fired by the company over the last five years represent 2% of its total workforce and around 5% of its branch workers.
If the firings were spread evenly over the course of five years, around 0.4% of its total employee base was laid off annually as fraudulent activity was detected.
Wells Fargo gained $2.6 million in extra fees from the fraud, which represents 0.0064% of the firm’s non-interest income last year and 0.003% of the company’s total income.
With over 40 million retail customers (and 70+ million total customers), less than 5% of these customers would have potentially been impacted by the fraud if we assume all 2 million accounts were unauthorized and no customer received more than one fraudulent account.
