Charlie Munger once said that he compares every possible investment to Wells Fargo… Why buy company X if it’s not as good/cheap as WFC? For weeks I’ve been slowly and steadily working my way through hundreds of small community bank stock filings looking for bargains. A good friend of mine lately has been the trusty old FDIC website where you can find current/historical financials on banks to your heart’s content…
But after a few more hours of sifting through Call Reports on tiny banks last night, I had a thought about Wells Fargo…
I have a whole file on WFC, which I think is probably the best bank in the country. Yes, my opinion mirrors Buffett’s, but I believe I would have reached the same conclusion regardless of the Master’s opinion after studying the bank for a long time and really spending time thinking about the importance of things like earning power, return on tangible assets, efficiency (cost structure) and scale among other things that Buffett talks about in his letters.
In a rare interview with Harvard Business School that was published online earlier this month, (it has since been taken down) value investor Seth Klarman spoke at length about his investment process, philosophy and the changes value investors have had to overcome during the past decade. Klarman’s hedge fund, the Boston-based Baupost has one of Read More
Note that I said I think it’s the best bank, but not necessarily the best investment (although you could certainly do worse than just owning WFC). But after sifting through hundreds of community banks over the past few months, I experienced somewhat of a serendipitous “light bulb moment” last night… maybe this is obvious to some, but it wasn’t to me until last night…
WFC Better Value?
Wells Fargo is likely to be vastly superior as an investment to the large majority of these smaller community banks, many of which trade at large discounts to tangible equity.
The reasons for my conclusion would have to be the subject of a series of posts, and in the near future I may begin writing some more ideas on why I like Wells Fargo and why I believe Buffett continues to buy WFC (which is interesting given the fact he’s not buying Coke, IBM, P&G or other favorite holdings).
I will likely write at least a few other posts on WFC alone because I think it’s a great business, it’s still probably undervalued, and it has made for some great historic case studies (i.e. Buffett, Greenblatt, and Berkowitz all made significant fortunes investing in WFC after the California real estate scare of the early 1990’s, a period that subsequently saw WFC stock rise 8 fold…. And more recently, Buffett made a comment where he basically said that he’d put 100% of his net worth into WFC if he could do that (which he couldn’t) when the stock traded down to $8 in early 2009…. A period that looks to be shaping up very similar to the one two decades ago, with WFC up 5 fold in the last 5 years).
But back to my original point… I started looking at community banks because even after a large run, many of them are still significantly undervalued and probably safer than they were a few years ago (loan losses are down, leverage ratios have improved, costs are under control, etc…). But last night after going through the financials of yet another mediocre cheap community bank, I pulled up my notes on Wells Fargo just to do a comparison. Although I knew most of these numbers, it’s interesting to look at them side by side next to the numbers of any given small bank stock.
WFC Key Numbers
At $41 per share, here are some of the ratios… check that, first let me briefly define (as close to laymen’s terms as I can get) a term you’ll often see these days associated with bank stocks:
- Pre-tax, pre-provision earnings, or PTPP—as it sounds, these are earnings before taxes and before accounting for the money that a bank sets aside (provisions) for future credit losses. Many analysts will refer to PTPP earnings as “core earnings” because they more closely resemble the cash earnings that a bank produces in any given year before paying tax.
- I look at PTPP, but I prefer to use simply pretax earnings after accounting for the provisions, assuming that the provisions represent a normal, or average amount (if not, you can adjust using an average of the last 10 years or so). I think it’s a slightly more conservative way to arrive at a value, but this might be getting too inside baseball…
The basic idea is to determine the price relative to normalized earning power, whether they are pretax or after tax.
So, let’s take a quick look at WFC’s valuation relative to earnings
- 10.8 times earnings
- 6.2 times pretax, pre-provision earnings (PTPP)
- 6.9 times pretax earnings
Pretty reasonable, if not downright cheap considering the quality…
And speaking of quality, let’s look at the actual earning power ratios. Here I’ll look at the normal ROA and ROE numbers, and also look at a number Buffett focused on in the early 1990’s when he first bought Wells Fargo & Co (NYSE:WFC), which is the return on tangible equity, and the pretax return on tangible equity (ROTE):
- ROA: 1.43%
- ROE: 13.0%
- Return on Tangible Equity: 18.3%
- Pretax ROTE: 27.3%
These are the numbers that really jump out at me when I look at Wells Fargo. The bank continues to produce really high quality returns on tangible equity.
“The Lowest Costs Wins”
One thing that Buffett often says that I think gets overlooked is that in businesses such as banking (or commodity businesses), the company with the lowest costs wins in the end, and Wells Fargo has the lowest costs:
In addition to low cost deposits (the most important funding source of a bank), WFC also has a superior efficiency ratio, which basically measures the level of operating costs that a bank has (Efficiency Ratio = Non-interest expenses/revenue).
These factors are important because this is where the margin of safety principle comes into play… As interest rates and other costs move in directions that are disadvantageous to banks, Wells Fargo & Co (NYSE:WFC) has a much larger cushion to withstand such impacts and still remain profitable.
Part of this cost efficiency comes from the economies of scale–one thing that WFC has that the community banks don’t have: