Motley Fool Hidden Gems Investing - Wells Fargo Steps Back

Episode Date: January 11, 2023

What does it say when a market leader steps back from….leading? (0:21) Asit Sharma discusses: - Wells Fargo, once the biggest player in mortgages, announces it is making a strategic shift - The role that the current state of housing plays in Wells Fargo's decision - Our brand new podcast, Stock Advisor Roundtable (10:15) Tim Beyers and Tim White take a closer look at "key person risk". Motley Fool premium members, click here to link your Motley Fool membership to a Spotify account and begin listening to this exclusive new podcast! And if you're not a member, you can get a preview of the show and learn how to get access here on Spotify! Stocks discussed: WFC, CRM, SFIX, GOOG, GOOGL Host: Chris Hill Guest: Asit Sharma, Tim Beyers, Tim White Producer: Ricky Mulvey Engineers: Rick Engdahl, Tim Sparks Learn more about your ad choices. Visit megaphone.fm/adchoices

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Because we have your number. We've got big news from a big bank and we've got big news about a brand new podcast. Motley Fool Money starts now. I'm Chris Hill. Joining me today, Motley Fool Senior Analyst Asit Sharma. Thanks so much for being here. Chris, as always, thank you for having me. Once upon a time, Wells Fargo was the biggest player in home mortgages. Today, we get the news that Wells Fargo is stepping back from the mortgage market. The bank says that they will focus on home loans for existing bank and wealth management customers. Here's immediately where my brain went when I saw this news, Asit, because I have a tendency, correctly

or incorrectly, to look at the housing market as having more and closer ripple effects than other industries. So, when I saw this news, I asked the question, does this say more about Wells Fargo or the housing market? What do you think? I think it's 60-40, Chris. I think this is 60% Wells Fargo and 40% the housing market, but that's a big number if 40% could be attributed to the external environment. This is a company that used to pride itself on being the biggest, baddest mortgage player in the market. As you point out, at one time it was the very biggest in home mortgages in the U.S. But over time, I think the board came to realize that biggest isn't always the best, especially in a slower growth industry like banking,

where you are trying to incentivize employees to grow much more quickly than competitors. I believe that this race to be big, stay big, and the like had a detrimental effect to the way that Wells Fargo approached the whole idea of sales, and it led to incentives having people do not so great stuff. You and I have talked in years past about different episodes in Wells Fargo's history where they've been called out by regulators for fraudulent activities. of this is a longer-term realization, especially by the newish CEO, Charlie Scharf, that we don't have to be so big. They look over their shoulder at other big banks who've engaged in much more of non-mortgage activities. These are fee-related activities, and they see a different business

model out there. I'll say also about the external environment, that 40%. This is an expensive business to maintain in an environment where long-term mortgage rates equivalent to a 30-year loan for a house have shot over 6%, close to 7%. So you have to maintain a huge amount of infrastructure if you're going to play this game, even though you're going to take a very small profit margin in such an environment. And in fact, you're going to see a very big decrease in your loan originations business, which is fee-based. And we can talk a little bit about this as we go on, but your thoughts on my first take on this. Well, again, that's why I posed the question that I did, because I thought whatever internal challenges Wells Fargo is

experiencing, if this was an amazing business to be in at this point in time, if this was a growing business, if the environment was favorable, even with those internal challenges, they would not be exiting the business to the extent that they are. Yeah, for sure. I mean, they would find a way to keep playing the game, but there's so much of legacy difficulty with the way they've approached the mortgage market. The fact that the risk in being so big outweighs the benefits. The fact that reputational risk has zinged them, now they have almost like a clean slate. They have this view of the world where people are just calling a halt to the idea of moving into a new home until interest rates subside. I'm not saying it gives them cover, but it

gives them a new perspective or a limited window in which to make some of these changes. I was referring to this split in what they get out of the mortgage business earlier. They of course make money by holding the mortgage collections. They also originate loans. That business has dropped dramatically in the first nine months for 2022, which we have figures on. Chris, in the nine months ended September 30th, 2021, their net gains on loan originations were almost 3.9 billion. That plummeted to just under 900 million, same period this year. This is another reason for them to say, if we're going to take a step back from this business, now is a good time.

Just start over with a white sheet of paper. They're not completely exiting this mortgage business, as you point out. They'll still service the customers they have. They have some set-asides to help historically underserved people. There's some racial equity they're trying to promote, so they have a program for that. But I will say this, this could end up being a slightly tactical rather than strategic move. If we see interest rates drop again and stay down, my money is then stepping back into the mortgage market. I don't think this necessarily has to be permanent for them,

but it makes sense now. By the way, I should point out the market reaction to this is largely positive. I mean, you know, a lot of times you see news of company X is essentially scaling back or exiting completely out of some initiative. And again, in the case of Wells Fargo, they used to be the biggest player in this space. But shares up half a percent today, that to me is a sign of approval from investors. Wells Fargo is reporting their quarterly earnings along with several other big banks, Friday morning. Why do you think they got this news out today? Was it just like, hey, we want Friday to be about the quarter and less about this news? I think it's, we want Friday to be about the bottom half of the top half of the banking

income statement, which is less about interest income. And it's more about the fee types of activities that you can generate. Those are higher margin activities. So I think that whatever happens with their port, and I don't know, maybe they had a halfway decent quarter in their mortgage business, but whatever happens, they want investors to start focusing on how this bank can be more nimble. For years and years and years, the bank told investors, biggest is best. We're going to have absolute profits, meaning large dollar profits hit the bottom line. We're not quite as concerned with margins. And today they're saying, we want to be more nimble like our competitors. We want to be agile. So let's start paying more attention to investment advisory feeds,

to lending related fees, to commissions, brokerage services, all that good stuff that competitors have been able to use to diversify their business models. I think that's what this is about. It'd be interesting to see what kind of questions they get on Friday and sort of where this goes from here. Because who knows, we may look back six, 12 months from now and say that actually was a turning point for the business. But I think back over the last, let's just call it eight years with Wells Fargo, the various problems they've had of their own making, there have been other points in time when you could look at them and say, well, hopefully they'll be able to move past this now. So we'll see. Before I let you go,

So today, we are actually, at The Motley Fool, we are launching our first ever member-exclusive podcast. It's called Stock Advisor Roundtable. This is available to members of Stock Advisor, Epic Bundle, and The Motley Fool's Advanced Investing Services. You can only find it in one place, which is Spotify. We've got a special partnership with Spotify that we're bringing this podcast through. And this is something you've been involved in. You're there in the first episode with our Chief Investment Officer, Andy Cross. What is one thing from this initial episode that folks can look forward to? Andy Cross In this first episode, Chris, we took the time to walk investors through our 10 foundational stocks,

and it was a lot of fun. There is a lot in this episode. You'll get a flavor for some of the time that we'll spend on individual stocks. You'll also get a flavor for some of the macro things that we're going to be talking about in 2023. I just want to make a really quick pitch with myself and Andy. This time, on a regular basis, this will be hosted by Brian Stoffel. You'll also hear Emily Flippen, who will be a regular contributor alongside the two of us, and Tom Gardner, CEO of The Motley Fool and all-around awesome stock picker, is also going to be dropping in on occasion. This is must-listen podcasting as far as I'm concerned. Again, if you're a member of one of those services, just check the link in the

description of this episode. We've got a link in the show notes for how to link your Motley Fool premium account to a Spotify account, so you can start listening. Asit Sharma, always great talking to you. Thanks for being here. Same here. Thanks so much, Chris. a visionary ceo can be an advantage for a company it can also create some unknowns for shareholders tim byers and tim white take a closer look at key person risk and how one less obvious example is playing out. This is something that I don't think is unique to tech, but when we talk about key person risk, what are we talking about? We're really talking about the risk to a company's bottom line, to their operations, to their profits, to their ability to make money from a single

individual or a set of individuals that are key to that company's functioning. And often it's either a founder or a CEO who's viewed as instrumental to a company or a key salesperson, a key technical resource that may have invented algorithms or has patents or something like that that are crucial to a company, that if that person became disabled or passed away or left the company, would be a material impact to that company's bottom line. And the material impact obviously could vary, but in the case of key person risk, we think the material impact could be significant. So, for example, there is a real belief that Mark Benioff, who is the co-founder of Salesforce.com, if Mark Benioff were to leave, would say, well, that person personifies not only the Salesforce ethos, but the culture and has been so intertwined with that business since its founding that it would materially change the company and potentially seriously impact its ability to perform financially.

So that is key person risk. And it does come in many forms. Before we get to a recent example, Tim, something that you said that was really interesting to me as we were talking before we came on the air is that it doesn't have to be a CEO. It can be somebody buried inside the company who's done something incredibly instrumental. And if that person were to leave, it would hamper the business in significant ways. Yeah, salespeople are often quoted as being key people because of their relationships, right? A lot of very high-end salespeople might have very close relationships with their customers, and those are personal relationships that they have worked very hard over time to develop. And if that person was to leave, anyone stepping in to try to rebuild those relationships would be a major disadvantage. And so to that end, companies can even take out insurance, key person insurance, to say, like, if this salesperson passes away or leaves, then the company gets paid by the insurance company some amount of money that is roughly equivalent to what that person was generating for the company for a few years for them to have the opportunity to go and find a replacement and get those relationships rebuilt. Can you imagine, let's just ballpark it for a second, can you imagine what the key person insurance policy on Steve Jobs would have been back in the days when he returned to Apple? Yeah, I would say in 2008, you know, I'm thinking just after the iPhone is launched and all this stuff is happening, I can't imagine that Apple did not have a key person insurance policy for Steve Jobs, right?

Like, it's impossible to get other kinds of insurance and to get loans and to do other things if the people looking at you are like, yeah, your company is great, except if this person goes away, you're toast. And thus, we're not going to lend you money or people aren't going to work for you or something like that. And so those kinds of insurance policies are often required as part of really large loans. You will often find these if you are investing and you're looking through financial filings. You will often find key person risk, and you may even be able to search the term key person risk inside financial filings. Sometimes that will appear in the annual report, the 10K, under the risk section, or also in the quarterly report. It's also commonly referred to as the 10Q, so you can find it there. And then there will be other times where, you know, this will really come to light as something you want to pay attention to.

So just recently, let's just take a recent example. We don't know for sure if Stitch Fix took out any kind of, let's say, insurance policy on Katrina Lake because the founder of Stitch Fix stepped down, I think a little more than a year ago now, Tim, to hand the reins to Elizabeth Spalding as CEO of the company. Well, relatively recently, early January, Elizabeth Spalding was removed. Katrina Lake was actually appointed CEO the day before she was removed. And now she has some incentives to find her replacement. I think this is an example of why key person risk is so important. So let me just read something here that I think you'll find pretty fascinating. So this is from the SEC filing.

It says, Miss Lake will receive no change in her annual base salary, which is currently $80,000. This is in her position as the executive chair and two options to purchase a total of 200,000 shares of the company's stock, exercise a price equal to the closing price as of January 6th when she was appointed. The first 150,000 shares will vest upon the earlier of either July 5th of this year, which is the first or the first day of employment of a successor, chief executive officer. And then there's a second option for 50,000 shares will vest upon the first day of the employment of a successor, provided her successor is offered the role prior to July 5th. So in other words, Tim, there is real incentive for Katrina Lake to say, we don't like you as a key person.

Can you find somebody for us who will replace you so we don't have to rely just on you? And if you do that, we will pay you a boatload more money. Right. And I think this is very common with tech companies in particular because so often they are founded by technical founders who are visionaries or may have specific technical skills that enabled them to found the company. And they were the ones who really drove the bus on that. And without them, a lot of that vision starts to fade away. And many companies have successfully navigated these waters and hired other CEOs and been just fine.

But many companies, absent their technical founders, have not. And that's one of the reasons that founder-led companies is one of the things we look for for investments. Yeah. Yeah, this is way more common to just maybe put a double down on this point. This issue is a lot more common in tech because in tech, a lot of products and a lot of the most successful products are intangible, meaning they're tied up with somebody who has created something unique. Usually that happens in code. Maybe it's a design.

And so the person who helped create this intangible product becomes intertwined with that product itself. So you could think of, for example, Sergey Brin and Larry Page at Google. They've been absolutely identified. Now, thankfully, Alphabet has grown beyond them. Bill Gates and Windows and Microsoft, thankfully, Microsoft has grown beyond them. But we also just talked about Mark Benioff as the co-creator of Salesforce. So sometimes they do get directly intertwined with the products that they've created. And in those particular cases, the cult of personality of tech does lead to this key person risk.

So what do you do about it as an investor? I don't know, Tim, that I am necessarily more interested in a company if they have proof of key person insurance. I think what's more interesting to me is if there's a diffusion of talent. I can see really interesting outside talent being attracted to the company as it scales. And I also think transparency has many benefits. But if you kind of go with the Ray Dalio idea of radical transparency, it might be a little much. But if the culture is one where a lot of knowledge is shared and people are constantly sharing with each other and there's a lot less sort of people holing up in their own little castles and building little fiefdoms, then it's much less likely you'll end up with little fiefdoms that one person leaves and they're the only person that knows something. And so that company culture of transparency is also a way to help combat key person risk. Yeah. And I would say the last thing on this, something that you might see inside of a company that is growing beyond its initial key person risk is a lot of organic development, new products that pop up inside that company because people have come in, found it as a fertile ground for doing interesting work, and they turn that interesting work into brand new products. And so when you see that, that might be an indicator that what was key person risk is getting less and less risky. One last thing that occurred to me is that ACWA hires, right, where a company will buy

another company mostly to get the talent of that other company or another way to get really strong people who have the ability to lead their own company into your organization and hopefully eventually have leadership roles, as we saw with people like Stuart Butterfield and other folks that were hired in Salesforce, but certainly other companies as well. Yeah. Yeah. That's another way to look at it. All right. Well, that's it for this week in tech on audio this week. Remember that we are live on Motley Fool Live on Fridays at 3 to 4 p.m. Eastern time. And we will see you then. Thanks so much for tuning in. Fool on. As always, people on the program may have interests in the stocks they talk about, and

The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill, thanks for listening, we'll see you tomorrow.