The Investor's Consigliere

Buffett on Valuation: Wells Fargo

This is a topical one--read it and you'll agree with Ecclesiastes that "there is nothing new under the sun."

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):

1. Banking is a mediocre and potentially bad business to be in.
2. 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.
3. 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.
4. 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.
5. Double-fortunately, if we buy Wells Fargo at its current price of 5x earnings, we'll make money in two ways: 

             a)  The company's ability to earn 20% on growing equity means its intrinsic value will grow at a                         good clip in normal times
             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"? 

Buffett on Valuation: Cisco Systems

OK, here is a better example of Buffett discussing valuation.  Unlike the last one, I think it gives insight into how his mind works.

This excerpt comes from back in the days of the technology stock boom.  Cisco Systems had a market cap of something like $500 billion dollars.  It's P/E ratio, according to my Value Line, was "not meaningful."  I don't know what that means, but I can safely say it was over 50x, and if you properly expensed stock options it would have been even higher.  It was very expensive, but many analysts rated it a buy, and produced detailed earnings forecasts which justified its current price.  Lots of mutual funds owned it, John Chambers was a celebrity, etc.

Someone asked Buffett about it, and here is what he said:

"Think about a company with a market cap of $500 billion.  To justify paying this price, you would have to earn $50 billion every year until perpetuity, assuming a 10% discount rate.  And if the business doesn't begin this payout for a year, the figure rises to $55 billion annually, and if you wait three years $66.5 billion.  Think about how many businesses today earn $50 billion, or $40 billion, or $30 billion.  It would require a rather extraordinary change in profitability to justify that price."

A very simple but powerful plausibility test.  Some simple arithmetic, the dividend discount model of valuing cash flows you learned in Finance 101, and the junior high school geometry concept that if you want to see if something is true, assume it is true and see what happens.  In this case, anyone who argued that Cisco was fairly valued at $500bn based on future earnings would have had to admit that what he was really arguing was that Cisco would be able to grow its earnings from the $3bn or so it was earning around the year 2000 to to $55bn next year, or $66.5bn three years hence, etc.  That's what's great about a great plausibility test:  You take an argument that seems vaguely true but you're not really sure, and figure out a way to restate it as an argument that is obviously unlikely to be true. 

(Here is another example of Buffett's ability to do instant plausibility tests.  It comes from the Lowenstein biography:

"Buffett didn't say much during the [Washington Post's] board meetings.  But occasionally a comment would spark him.  At one meeting, Jeffrey Epstein, a young M.B.A. who was scouting for new fields of investment, gave an overview of what consumers were spending in each part of the media and entertainment industry.  His figure for home entertainment was $5 billion.

Buffett's bushy eyebrows went up about three feet.  'That $5 billion is a pretty interesting number,' he noted.  'That means if there are twenty million teenagers in the United States they are all spending $20 every month on video' . . . It was suddenly clear that Epstein's figure, if true, was unsustainable.")


In my opinion, the investor who makes this argument (especially if he's doing it unrehearsed) gets way more points than the investor who says "Of course it's overvalued, look at the P/E!" or the one who says "young man,  I was around during the time of the Nifty 50 and we know how that turned out [not so badly, but that's another story]."  All three arguments are correct, and subsequent events worked out well for each of them.  But only the first argument has that cleverness that I'm looking for.

Buffett on Valuation: Western Securities, NAFI, and Daehon Flour

The first entry in our "Buffett on Valuation" series comes from a 2006 talk Buffett gave to students at the Columbia School of Business in New York:

Reading has made him rich over time. He told the story of going through Moody’s annuals in 1951. “It was absolutely a question of turning pages”. On page 1433, he found Western Insurance Securities. Its earnings per share were as follows: 1949 -$21.66, 1950 - $29.09. In 1951, the low-high share price was $3 - $13. He went to a broker and read the Best’s Insurance manuals, and talked to agents – it was a perfectly fine company with nothing wrong. Ten pages later, on page 1443, he found National American Fire Insurance (“This book really got hot towards the end!”) NAFI was controlled by an Omaha guy, one of the richest men in the country, who owned many of the best run insurance companies in the country. He stashed the crown jewels of his insurance holdings in NAFI. In 1950, it earned $29.02. The share price was $27. Book value was $135. Buffett found it fascinating that this company was located several blocks from the broker where he worked. His fellow brokers were bright, rational people whose job it was to buy cheap securities, and they refused to buy NAFI, instead investing in “blue chips”.

He then took out a copy of the 2005 Korean Stock Market guide. It was more of an almanac than a brokerage report. It was sent to him for free by a broker. “If it had been $10, I wouldn’t have paid for it.” Based on the recommendation of a friend who thought South Korean stocks were cheap, Buffett spent 5-6 hours leafing through the pages and put together a $100m portfolio of 20 or so companies. Daehan Flour sold 25% of the flour in South Korea, which had a large and stable economy. It’s earnings over the last few years: 12,870 won, 18,000 won, 22,830 won. It had over 100,000 won in securities. The stock price was 38,000 won. “You have to make money buying stocks like this at 2x earnings. Brokers aren’t going to tell you about Daehan Flour


You may be thinking "What's so elegant and clever about saying you bought a stock because it was trading at 2x earnings?"  My answer is . . . nothing, you're right.  This is a terrible example with which to make my case that great investors think about valuation more elegantly and cleverly than those who merely buy stocks that are "historically cheap." 

On the other hand, there is a difference between "historically cheap" and the valuations Buffett cited in the passage above.  These valuations belong less to the realm of history than fantasy, so they're more like fantastically cheap.  So Buffett's greatness in this case not his subtle mind but his ability to look for and find these little gems while many others focus on stocks that everyone else has heard of and are trading at 15x earnings instead of the 20x of a few years ago.  Good enough, especially if you are dealing with small sums of capital.

The next example will be better, I promise.

Buffett on Valuation: Introduction

Introducing a new category:  Buffett on Valuation.

As you know, this blog is about identifying great investors.  As I've written about before, one way to identify a great investor is to understand his/her investments.  There is no shortage of investors pitching their investment ideas: you can find them in the popular business press, and also in more specialized publications like Outstanding Investor Digest and Value Investor Insight, as well as stock message boards, everything from Yahoo! to the members-only Value Investors Club.

To investors trained in the Buffett school of value investing, an investment "thesis" contains basically two parts.  The first part is an argument about the nature of the business itself, especially its competitive advantage or "moat," in Buffettspeak.  The second part is an argument that the business is undervalued.

In my opinion, the stock "pitchers" out there in aggregate do a good job on the first part.  Buffett himself has been more than generous here--he loves to explain what makes a good business.

On the second part, however, I think the average stock pitcher does less well.  Too often I find that when an investor argues that a stock is undervalued, his argument comes down to the fact that the stock is historically cheap, usually on a price/earnings or price/book value or price/cash flow basis.

Now it may be possible to be a good investor by simply a) identifying a "good business" and b) buying it when it's historically cheap.  Joel Greenblatt's recent book advocates just such a "naive" approach.  But I have two problems with this approach:

1)  I'm not looking for good investors, I'm looking for great investors.

2)  When I read a stock pitch, I'm not just trying to figure out how well the particular idea will do, I'm trying to figure out how well the investor making the argument will do over the course of his career.  Simply put, I'm trying to figure out how smart he is.

So I am looking for something more than "it's historically cheap" from my investment managers when they talk about valuation.  Something more elegant, more clever, something that gives me insight into the mind of the person making the argument.

Who does this well?  Would you like to guess . . .?  Correct, Warren Buffett!  Interestingly enough, I believe that Buffett talks comparatively little about valuation in his public remarks.  But when he does talk (or write), in my opinion his valuation arguments do exactly what I want them to do--they tell me "this person is very smart.  Not only will this particular investment turn out well, but his next one and the next one after that will too."

To try to explain what I mean, I will compile a dossier of every instance I can find of Warren Buffett discussing valuation and put it on this blog under the "Buffett on Valuation" category.  So stay tuned.