Importance of ROIC Part 5: Four Decades of Wells Fargo History by John Huber, Base Hit investing
“Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago… a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.”
–Warren Buffett, 1992 Shareholder Letter
In the last post, I compared two hypothetical companies using some basic math regarding returns on capital.
It helps to keep this general formula in mind, which is a rough estimate for how fast a business with compound intrinsic value over time… A business will compound value at a rate that approximates the following product: ROIC x Reinvestment Rate.
To look at a real life simple example, let’s look at a company I’ve discussed before: Wells Fargo. Just for fun, I decided to check out the price in 1972, since I like looking at historical annual reports and I wanted to use a year where the stock market was in a bubble (and about to crash 50%). 42 years ago, the stock market was at the end of what is now known as the “Nifty-Fifty” bubble. It was a stock market where many large cap stocks were being bought at 40-50 times earnings or more by newly created mutual funds that were gathering assets at a feverish pace and were putting this inflow of cash to work at ever rising stock prices regardless of valuations. We know how this ended: by 1974 stocks had lost half their value, mutual funds went from uber-bullish at the top of the market to uber-bearish at the bottom, and valuations became much more reasonable.
I wanted to use a year where stock prices were generally expensive to ensure that I wasn’t using data from a market bottom, and to also show that even in a bubble year, a business that subsequently continues to produce high returns on capital will create shareholder value.
High Returns on Incremental Investments Leads to Compounding Value
In 1972, Wells Fargo was trading at $0.59 per share (obviously, adjusted for splits). Today the stock trades around $52 per share, roughly 88 times the price it was in the 1972 market top. In other words, Wells Fargo & Co (NYSE:WFC) has compounded its stock price at 11.4% annually, not including dividends. If we include dividends, shareholders have seen around 14% total annual returns over the past four+ decades.
How did this happen? There are many reasons, but let’s just look at the math (i.e. the results of management’s execution, we’ll leave the “why” for another time).
So to review this math, I pulled up an old annual report showing financial data from the early 70’s. The 1974 WFC annual report is the first one to provide market prices for the stock, as well as book value data. So I got 1972’s numbers from the ‘74 report.
Here are some key numbers to look at from 1972 (again, I adjusted these for splits):
- 1972 Wells Fargo Book Value: $0.40
- 1972 Wells Fargo Stock Price: $0.59
- 1972 Wells Fargo ROE: 10.9%
- 1972 Wells Fargo P/B Ratio: 1.5
Let’s compare that to the numbers from halfway through 2014:
- 2014 Wells Fargo Book Value: $31.18
- 2014 Wells Fargo Stock Price: ~$52
- 2014 Wells Fargo ROE: 13.5%
- 2014 Wells Fargo P/B Ratio: 1.6
So in the past 41 and a half years, Wells Fargo has:
- Compounded Book Value at 11.1%
- Compounded Stock Price (not including dividends) at 11.4%
- Earning power has compounded at 11.7% (earnings have grown from around $0.04 to over $4.00 per share)
- P/B Ratio is roughly the same as it was 42 years ago
As you can see, the intrinsic value of the enterprise (as evidenced by the compounding net worth and earning power) has compounded very nicely over a long period of time, which has led to similar returns for shareholders. If we include dividends, shareholders have seen around 14% annual returns, even if they invested toward the top of the 1972 bubble.
This year I spent a lot of time paging through many old Wells Fargo & Co (NYSE:WFC) annual reports. If you look back over time, you’ll find that Wells Fargo produced mid-teen returns on its equity capital over the past four decades:
Some interesting things to note about the last 42 years:
- Wells Fargo was profitable every single year (42 for 42)
- Earnings increased from the previous year 35 out of 42 years
- ROE averaged about 15%
And this isn’t in the table above, but worth repeating:
- Wells Fargo book value compounded at 11.1% since 1972
- Wells Fargo stock price compounded at 11.4% since 1972 (not including dividends)
- Wells Fargo earnings power compounded at 11.7% since 1972
You’ll also notice that in most years, it retained 2/3rd of its earnings and paid out the other 1/3rd in dividends. So I’m using some back of the envelope thinking here and simply saying that the reinvestment rate is the level of earnings Wells Fargo has to allocate after paying dividends (note: some of these earnings could be used for buybacks, acquisitions, etc…).
Remember the back of the envelope math:
- A business will compound at the product of two factors:
- The percentage of earnings it can retain and reinvest
- The rate of return it can achieve on that incremental investment
So it’s just the ROIC times the percentage of earnings it can reinvest (aka the reinvestment rate). In the example of Wells Fargo & Co (NYSE:WFC), I used equity capital (and thus, ROE), and the growth of book value as a proxy for the growth of intrinsic value.
By the way, you could also look at ROA, which might be a better way to compare core earning power of the bank. However, I wanted to look at ROE in this case since we are buying the equity when we buy the stock and we accept the given amount of leverage (ROE = ROA x Leverage).
Also, ROE averages over a long period of time (less dividends) is a good back of the envelope way to eyeball the growth in book value. And for a company like Wells Fargo, this long term compounding of net worth will approximately move in lock step with intrinsic value growth—and also stock price compounding… again, over a long period of time.
As an interesting side note, Wells Fargo carries less than half the leverage in 2014 than it did in 1972. In any event, we’ll compare the returns on equity capital to see how shareholder capital compounded over time.
So as you can see: 15% ROE and 66% Reinvestment Rate = 10% Intrinsic Value (Book Value) CAGR.
You’ll notice it’s not exact, as book value compounded at 11%, and this back of the envelope math suggests book value will compound at 10%. The difference has to do with the aggregate effects of things like share buybacks/issuances, dividends, acquisitions, etc… but the basic idea should demonstrate that a business like Wells Fargo that can produce 15% returns on equity capital will grow the value of its net worth and earning power by 10% or so if it can reinvest 2/3rds of its earnings at that rate of return.
Note: I went