Monday, January 25, 2010

Buffett on Wells Fargo

Some thoughts from Warren Buffett in this CNBC interview on Wells Fargo:

They've run into much larger losses than anybody anticipated three or four years ago but they can handle them very easily. Last year we talked about 'em having 40 billion of pre-provision income in 2009, and you know, they had it, and that easily handles 20 billion, roughly, of losses.

Becky Quick of CNBC then asked what he thought of Wells needing to issue a lot more shares. Buffett's reply:

I didn't like it. (Laughs.) No, I mean, the government forced them to issue the shares. The government's done a lot of good things for the economy and net I'm a beneficiary and Berkshire Hathaway is a beneficiary of the things overall they've done. But they cost us real money at Wells Fargo.

Speaking to Joe Kernen of CNBC, he also had this to say about Wells Fargo's revenue...

...actually when the stress test was done in the spring of last year, that's where the people evaluating them were way off, was on the revenue number. Wells did not disagree with them on the possible losses number, but they felt that the people just didn't understand the revenue potential, that were looking at them, and I agreed with them.

Superior revenue generation and low cost deposits allows Wells Fargo to earn higher pre-provision pre-tax income on its asset base than most other banks. As a result, Wells Fargo can absorb more losses during downturns through this earning power and will (all things being equal) earn a higher return on equity across business cycles. I agree that Wells Fargo did not need to raise capital but it still worked out okay for shareholders. The key reason being that they were never forced to raise capital at an extremely low price...just an annoyingly low price.

The stock should be quite a bit higher in 5 years. It's just that this process of forced dilution took some of the upside away. Personally, I don't think it is as unfair as Buffett says. It could not have been handled much better given the circumstances in my view. It would be difficult to have a stress test that was fair to every bank. The big picture here though is that WFC has approximately 50% more shares outstanding (before the crisis they had ~3.4 billion, now they have roughly 5.2 billion). That sounds bad on the surface but consider the following: By my math, they roughly doubled their asset base (from $ 600 billion to 1.2 trillion) and long-term earning power (pre-provision pretax from $ 20 billion/year to $ 40 billion/year) through the acquisition of Wachovia during that time. I'll take 50% dilution with a 100% increase in earning power any day. The bottom line is normalized after tax income should easily exceed $ 20 billion/year and the market value of the bank is $ 141 billion using last Friday's close.

Obviously future forced dilutions would damage this thesis and, though it seems remote right now, that risk of dilution remains out there.

Adam

Long position in Wells Fargo

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