Tuesday, September 27, 2011

Buffett on Wells Fargo: Berkshire Shareholder Letter Highlights

Below is an excerpt from the 1990 Berkshire Hathaway (BRKa) shareholder letter.

Starting in 1989, and continuing into 1990, Warren Buffett was buying lots of Wells Fargo (WFC) shares for the first time. Here is what he had to say about Wells back then:

Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings. The exception was Wells Fargo, a superbly-managed, high-return banking operation in which we increased our ownership to just under 10%, the most we can own without the approval of the Federal Reserve Board. About one-sixth of our position was bought in 1989, the rest in 1990.

The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.

This next excerpt from the letter sounds like something that would just as aptly describe banks during the more recent financial crisis...

Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. 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 bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.

As always, the price paid is the best way to regulate the specific risks of an investment. Future outcomes are always uncertain and unknowable despite what those in the business of forecasting say.

Most forecasters are, if nothing else, reliably unreliable.

"We have two classes of forecasters: those who don't know, and those who don't know they don't know." - John Kenneth Galbraith in the Wall Street Journal (January 1993)

Making a judgment on the known strengths and weaknesses of a business and whether the price is low enough to provide an acceptable margin of safety seems, by comparison, more doable on a regular basis.

The good news is effective macro forecasting is not a prerequisite of successful investing.

"We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen." - Warren Buffett in the 1994 Berkshire Hathaway Shareholder Letter

"A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results." - Warren Buffett in the 1994 Berkshire Hathaway Shareholder Letter

Now Back to Wells Fargo.

Normally, at 5x after-tax earnings, if the investor has a long-term investing horizon, an awful lot has to go extraordinarily wrong for even a decent business (for a lousy business like an airline no multiple is cheap enough...all bets are off).

At that kind of multiple, the problem can't just be something like ugly headlines or a dysfunctional board. It has to be along the lines of a collapse in the core economics of a business (economic moat wrecked) or an event that causes massive shareholder dilution at prices well below intrinsic value (often the result of extreme leverage).

Most times, not much has to go right with an equity investment that cheap. A multiple that low implies the business will stagnate or maybe even shrink a bit. If a business shrinks yet maintains most of its favorable economic advantages, with patience very solid long run returns can still be had at that kind of multiple.

So a 5x multiple (a 20% earnings yield) compensates the investor for quite a lot of risks and uncertainties.

Now, a bank always has a unique set of risks mostly related to the inherent leverage used but also the systemic variety. In the context of today's investing environment and, considering other available very inexpensive non-financial investment alternatives, I'm not sure those kinds of risks are worth the trouble.

Buffett made the judgment back in 1990 that Wells Fargo still had an excellent franchise and terrific economics and once the noise of the moment passed its value would become clear. Berkshire Hathaway shareholders were compensated handsomely for Buffett getting that judgment right.

He seems to be making the same call this time around with Wells Fargo and U.S. Bancorp (USB). If the worst kinds of systemic failures do not occur some of the better banks like Wells and U.S. Bancorp will likely end up with, if not the same as what has happened since 1990, a solid long run outcome.
(Buffett's Bank of America: BAC investment is a little different since he went the preferred shares route and the terms are uniquely favorable.)

Once again, it's just that considering the number of attractive alternatives available, I'm not convinced banks need to be anything more than a small portion of an equity portfolio.

The risks unique to investing in banks have always been significant. The better banks right now would be more interesting if there were not so many other 5-7x multiple non-financial stocks.

Adam

Long BRKb, USB, and WFC

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