In the 1990 Berkshire Hathaway letter to shareholders, Buffett writes about his purchase of a big block of stock of Wells Fargo. It reads like a mini-entry in Value Investor Insight or the Value Investors Club. He starts by discussing the banking business in general, which isn't good, but Wells Fargo is an exception mostly because of its management:
Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings. The exception was Wells Fargo, a superbly-managed, high-return banking operation in which we increased our ownership to just under 10%, the most we can own without the approval of the Federal Reserve Board. About one-sixth of our position was bought in 1989, the rest in 1990.
The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.
Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a "cheap" price. Instead, our only interest is in buying into well-managed banks at fair prices.
With Wells Fargo, we think we have obtained the best managers in the business, Carl Reichardt and Paul Hazen. In many ways the combination of Carl and Paul reminds me of another - Tom Murphy and Dan Burke at Capital Cities/ABC. First, each pair is stronger than the sum of its parts because each partner understands, trusts and admires the other. Second, both managerial teams pay able people well, but abhor having a bigger head count than is needed. Third, both attack costs as vigorously when profits are at record levels as when they are under pressure. Finally, both stick with what they understand and let their abilities, not their egos, determine what they attempt. (Thomas J. Watson Sr. of IBM followed the same rule: "I'm no genius," he said. "I'm smart in spots - but I stay around those spots.")
Now Buffett turns to valuation, which regular readers of his letters know he seldom does:
Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled - often on the heels of managerial assurances that all was well - investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.
Less than five times earnings counts as cheap, so cheap you don't really have to be elegant about it. But with bank stocks there is a catch: your earnings may disappear, and your shareholder capital along with it, as a consequence of poor lending. Buffett addresses this with a simple "stress test." In other words, he asks himself what would happen in a, if not worst-case, then at least a very bad-case scenario:
Of course, ownership of a bank - or about any other business - is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.
None of these eventualities can be ruled out. The probability of the first two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.
A year like that - which we consider only a low-level possibility, not a likelihood - would not distress us. In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity. Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices.
Summarizing Buffett's logic (some of which is unstated, so I try to read his mind a little):
- Banking is a mediocre and potentially bad business to be in.
- Wells Fargo on the other hand, largely because of its management, is a good business, with a history of earning 20% returns on equity. Not only that, but it can retain much of that equity, which in turn earns 20%. A business like that should sell at a premium--perhaps even at an earnings yield (the inverse of the P/E ratio) below the yield on treasuries (about 8% at the time). Wells Fargo sells at an earnings yield of 20% (the inverse of its 5x P/E ratio. So it looks really cheap, as long as it can get back to its 20% ROE ways.
- California real estate, where most of Wells Fargo's loans are concentrated, could get really ugly. In order for Wells Fargo to emerge as the 20% ROE powerhouse we know it can be, it must survive this period.
- Fortunately, even in a really ugly scenario, Wells Fargo will just about break even. We may have to wait a year or two, but we're confident we'll get back to pre-recession profitability.
- Double-fortunately, if we buy Wells Fargo at its current price of 5x earnings, we'll make money in two ways:
b) The market will eventually revalue the company from 5x earnings to something more befitting.
6. The money to be made in part 5) is worth waiting a year or two for, and part 4) demonstrates that you won't go bankrupt in the interim. So it's a good bet.
Compare Buffett's reasoning to the many investors who today tout Citigroup on TV and in print. I can't tell you whether Citigroup is a buy, but pay attention to the reasoning of those who are bullish. Do they go beyond "it's historically cheap" or "I think Vikram Pandit will turn it around" or "It has a great franchise"?