I wrote a post about screening for quality bank stocks and another one here about Wells Fargo vs Cheap Community Banks and thought I’d post on some other comments I have here. Some of these thought might sound contradictory (everyone wants to separate stocks into categories based on quality/earnings and cheapness/assets). It’s not black and white, and all we’re really trying to do is figure out what something is worth and pay less for it. As Alice Schroeder has said, if Buffett were handed a dollar and asked to pay 50 cents for it, he would (despite the fact that the dollar bill has no moat!). So the first thing to remember is that we are trying to determine value in relation to price, regardless of what “category” the investment falls into.
I love looking at cheap stocks. When it comes to banks, I’ve traditionally started by looking at big discounts to tangible book value. But I’ve spent a lot of time thinking about why Buffett keeps buying Wells Fargo (which is the subject of another post I have to organize at some point).
There are different reasons for this, which I’ll discuss later, but for now, the basic question I’ve considered is why does Buffett get so enthusiastic about paying 2-3 times tangible book for banks? And it’s not because of his size. He easily could have plowed much more capital into large banks like Bank of America Corp (NYSE:BAC), Citigroup Inc (NYSE:C), and many other large liquid banks when they sold for significant discounts to tangible book (I realize he made some investments in some of these “other banks” but they were dwarfed by the size of his WFC position). Of course, the simple answer is that he feels Wells is the better business, and of course that’s true. But what specifically does he like?
See my last post for some more thoughts on Wells Fargo & Co (NYSE:WFC), and I’ll have more to say later, including some comments on the 1991-1993 annual reports that Buffett, Berkowitz, Greenblatt, and others were looking at in real time when they decided to make significant investments into Wells Fargo in the early 1990?s.
But for now, one thing to keep in mind when using simple valuation metrics like P/B is another Buffett comment on banks:
“You don’t make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on.”
I think what Buffett implies here is to not get too caught up with discounts to tangible book values if you plan to be a long term owner of the business. Of course, that’s how Buffett thinks of himself: a long term business owner. Many pay lip service to this, but few actually think this way. I’m not sure that everyone buying bank stocks at huge discounts to tangible book necessarily think this way. They most likely are thinking about flipping their discounted merchandise to someone else once that merchandise gets priced fairly.
For example, you can buy a bank at 0.7 times book, sell it at 1.0 times book for roughly a 50% gain… a very simple strategy, and one that I like to consider as well… and not that this is right or wrong strategically, but it’s definitely not how Buffett thinks, and I don’t think he thought this way in the 50?s and 60?s either, as I’ll discuss when I review my Commonwealth Bank case study when I have time later.
Buying and selling discounted merchandise is a very acceptable idea and it likely works over time with these banks. One of Irving Kahn’s first jobs when he went to work for Ben Graham was to make a list of all the bank stocks trading below .7 P/B.
Buffett does things differently, which doesn’t necessarily mean better, but it has also certainly worked. One thing he looks for are the banks that consistently have the lowest costs and determines that their cost structure (low-cost deposit base) along with their scale and size are huge competitive advantages. He is willing to pay well over book, and in some cases 2-3 times tangible book for quality banks like Wells Fargo, US Bank, M&T and others.
How has this worked out over time?
Very well… We all know about Wells Fargo, but think about this: In the last 3 decades, Wells Fargo stock price has averaged about 16% per year including dividends! Wow, the S&P made about 8.5% CAGR before dividends during that time. Including dividends, let’s call it about 11% per year for the S&P.
M&T Bank Corporation (NYSE:MTB), another Buffett holding and a very high quality bank, has actually been one of the greatest performing stocks over the past 30 years, going from $1 to $113, and including dividends has averaged about 18% compounded annually!
Note: I’m assuming about 2% annual dividends (which likely is on the conservative side) because I didn’t go back and check dividend yields for each year