Friday, September 30, 2011

Buffett on Wells Fargo - Part II: Berkskhire Shareholder Letter Highlights

A follow up to this post.

Warren Buffett, in the 1990 Berkshire Hathaway (BRKa) shareholder letter, wrote the following about Wells Fargo (WFC):

Of course, ownership of a bank - or about any other business - is far from riskless. 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 financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's 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 financed 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 first two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. 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.

A year like that - which we consider only a low-level possibility, not a likelihood - would not distress us. In fact, at Berkshire 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.

When the above was written the extensive use of derivatives was not in vogue yet. Their current prevalent use create systemic risks and risks unique to each institution that is difficult to gauge.

From the 2002 Berkshire Hathaway shareholder letter:

...derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is running.

The shares of Wells Fargo have increased in value well over 1,800% including dividends since Buffett wrote about the bank in the 1990 letter (though Buffett has bought many shares since with lesser gains). I doubt many banks will produce those kind of returns over the next twenty years or so but some of the better ones will certainly do quite well.

It's an example of what high return on equity (or preferably high return on capital for a non-financial) bought at 5x earnings, what Buffett paid for Wells back then, can produce in value when compounded over 20 years.

Yesterday's post covered this. Pay a lot less than what a business is worth now and make sure it is capable of producing a high return on tangible capital in the future. The cheap price provides a margin of safety in the near term. The high return on capital drives value long-term.

Joel Greenblatt on Stocks

Still, as I said in the earlier post, with so many inexpensive non-financial businesses available I'm not certain any bank is worth the trouble (considering the unique risks involved with owning shares of a bank) for most investors.

Adam

Long BRKb and WFC
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