Warren Buffett’s Wells Fargo Investment: What Are The Odds?by Sanjay Bakshi, via Slide Share
What Are the Odds?
“Take the probability times the amount of possible loss from the probability of gain times the amount of possible gain. that is what we are trying to do. its imperfect, but thats what it is all about.”- Warren Buffett
The Primacy of the Expected Value Table
“Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks.” – Warren Buffett
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 banks numbers were to be trusted. “Aided by their ?ight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than ?ve times after-tax earnings, and less than three times pre-tax earnings.”
Three Risks: 1. Earthquake 2. Systemic 3. Real estate exposure
“Of course, ownership of a bank – or about any other business – is far from risk-less. 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 ?nancial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run.
“Finally, the markets 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 ?nanced 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?rst two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. – Warren Buffett
“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.” – Warren Buffett
A year like that – which we consider only a low-level possibility, not a likelihood – would not distress us. “In fact, at Berkshire Hathaway 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.” – Warren Buffett
Fear is a Foe of the Faddist, but a Friend of the Fundamentalist
“The best thing that could happen from our standpoint is to have markets go down a tremendous amount. If you asked us next month whether wed be better off if the stock market were down 50% or if it remained where it is now, wed tell you that wed be better off if it were down 50%. Were going to be buyers of things over time. If were going to be buyers of groceries over time, wed like grocery prices to go down. If were going to be buying cars over time wed like car prices to go down. We buy businesses. We buy parts of businesses called shares. And were going to be much better off if we can buy those things at attractive prices than if we cant. We don’t have anything to fear. What we fear is a long, sustained, irrational bull market.”
“It’s not that hard to learn. What is hard is to get so you use it routinely almost everyday of your life. The Fermat/Pascal system is dramatically consonant with the way that the world works. And it’s fundamental truth. So you simply have to have the technique.” – Charlie Munger
Fermat/pascal Letters: http://www.york.ac.uk/depts/maths/histstat/pascal.pdf
Numbers in our words
Warren Buffett on Debt
Our consistently-conservative?nancial policies may appear to have been a mistake, but in my view were not. In retrospect, it is clear that significantly higher, though still conventional, leverage ratios at Berkshire would have produced considerably better returns on equity than the 23.8% we have actually averaged. Even in 1965, perhaps we could have judged there to be a 99% probability that higher leverage would lead to nothing but good. Correspondingly, we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt ratio to produce a result falling somewhere between temporary anguish and default.
We wouldn’t have liked those 99:1 odds – and never will. A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns.
If you hand me a gun metaphor
Severe change and exceptional returns usually don’t mix. Most investors, of course, behave as if just the opposite were true. That is, they usually confer the highest price-earnings ratios on exotic- sounding businesses that hold out the promise of feverish change.
That prospect lets investors fantasize about future pro?tability rather than face today’s business realities. For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be.
“We make bricks in Texas which use the same process as in Mesopotamia.” – Charlie Munger
Warren Buffett has made most of his money in businesses which you may consider as BORING – Carpets, furniture, insurance, candy, cola…
See full slides below.