Sunday, May 3, 2009

Warren Buffett: "I Apply My Own Stress Test"

From a recent CNBC interview:

BUFFETT: I can tell you, I apply my own stress test and they passed it with flying colors.

BECKY QUICK:
You apply your own stress test to Wells Fargo? How do you do that?

BUFFETT:
Sure. Well, I do it by looking at the details of their operation. Wells Fargo obtains their money, which is the raw material, they obtain their money cheaper than anybody else. You can look at the figures for every bank and you would be startled at the trillion dollars, roughly, that Wells Fargo gets from depositors, and to some extent from debt -- how much more cheap, how cheap that is compared to most of the other big banks. If you're a copper producer, and copper is selling for two dollars a pound, and you want to measure the stress of copper going to $1.30, for a guy whose production cost is $1.50, you know, he's got problems. If his cost is a dollar, he doesn't have problems. And Wells, in terms of its raw material costs, is better situated than any large bank, by some margin. So, it's built to sustain a lot.

The comments above are related to a core investing concept of Warren Buffett's that is worth repeating. What produces excess rates of return?

According to Buffett it is...

...a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.

Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic Goodwill. Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry.
- 1983 Berkshire Hathaway (BRKa) Shareholder Letter

The better banks produce excess returns by a) having a solid consumer franchise and b) a durable low cost position (i.e. an ability to obtain cheaper deposits than competitors).

The capitalized value of these excess returns is economic Goodwill.

While you will not find this type of Goodwill on a balance sheet, it is very real in an economic sense. You certainly will never find it in TCE (Tangible Common Equity) which is why that measure cannot possibly tell you the health of a bank.*

- When value of the product to the purchaser is the major determinant of selling price...excess returns can occur (Examples: Coca-Cola: KO, Wrigley, and See's Candies)

- When a company is the durable low cost producer in an industry...excess returns can also occur (Examples: Wells Fargo: WFC, and GEICO)

The better businesses have economic Goodwill but many businesses do not. By the way, a lot of complex math is not required. While you have to know how to interpret financial statements most of the important work is qualitative (strength of brands, products, distribution, culture, management etc).

Berkshire's stock did not go up over 90,000% since 1977 by carefully timing stock trades, sector rotation strategies, complex quantitative analysis etc. It was done by owning the right businesses then allowing the power of compounding do the heavy lifting. Keep in mind, almost ten of those 32 years was the so-called lost past decade for stocks. Also, Buffett's investment returns in the 20+ years he invested prior to 1977 are equally impressive so we are talking about a 50+ year track record.

$10k invested Berkshire in 1977 is worth over $ 9 million today

$10k invested in the S&P 500 in 1977 is worth just over $ 70k today

The difference? Berkshire has always owned stocks or businesses with tons of economic Goodwill while the S&P 500 has many businesses in it that do not have such economics working for them.

A satisfactory or better outcome accomplished with minimal trading activity.

It's buying great businesses at the right price and allowing Newton's 4th Law to work.

Adam

Long Berkshire, and Coca-Cola, and Wells Fargo

* Regulators, of course, have to operate under existing accounting rules and other regs while I am strictly looking at this from an economic point of view. Banks may be forced to raise capital for many technical or even political reasons. That does not mean it necessarily makes economic sense for each individual bank. There are some banks that do need capital but it's not because of low TCE. It will be because they lack earning power relative to the quality of their assets.
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