Friday, June 6, 2014

Wells Fargo vs S&P 500

From the most recent Berkshire Hathaway (BRKashareholder meeting:

The intrinsic value of any business is the present value of all cash distributed between now and Judgment Day. - Warren Buffett

Stock prices can fluctuate -- and, well, almost certainly will fluctuate -- much more so than a fair estimate of per share business value over time.
(Jeremy Grantham, in this letter, provides a useful long-term chart along these lines. See Exhibit 1 on page 8.)

Investing well means mostly learning to ignore what end up being costly distractions. There's just too much coverage of, and energy spent on, what ends up mostly being noise.

Sometimes, it's worthwhile to step back a bit.

With this in mind, let's take a look at the S&P 500's earnings before the financial crisis:

2006 S&P 500 earnings = 87.72 (peak pre-crisis earnings)

S&P 500 at year-end 2006 = 1,418.30

P/E = 16.2

2013 S&P 500 earnings = 107.45

S&P 500 = 1,940.46 (yesterday's close)

P/E = 18.1

% increase in earnings from 2006 to 2013 = 22.5%

A snapshot of earnings -- whether a company or, in this case, an index of many companies -- is only useful if it serves as a reasonable representation of a normalized earning trajectory going forward (over many years); it's only useful if it's a reasonable proxy for all the cash that will be distributed going forward. I'm sure there are all kinds of opinions about how S&P 500 earnings might change over the next few years. Well, I certainly never try to figure out such a thing (that window of time is way too small to be meaningful) even if I think odds are rather good that, let's say 10 or 20 years from now, S&P 500 earnings will likely be quite a bit higher than now.

To me, it's better to ignore short-term predictions. Ditto for fluctuations unless they happen to serve the investor in some way.

Other than choosing to own quality businesses in the first place, it is price, at least up to a point, that can be used to manage risks.*

Sometimes -- in fact, I'd say often -- extreme amounts of patience followed by decisive action will be required to buy enough at the right price.

Consider the wide range of prices that have been paid for what is not terribly difficult to estimate normalized S&P 500 earnings.

Even if the earnings power of the S&P 500 happens to drop dramatically in any given year, its intrinsic value is based upon the estimated earnings trajectory on a normalized and conservative basis over the long haul.
(A 50% drop in earnings in the short run might lead to a similar drop in market prices. That doesn't mean intrinsic value changed by that much.)

Since estimates like this are necessarily within a range, when in doubt choose the lower end of the range to estimate value.

The market prices fluctuate far more than the combined intrinsic value of those many S&P 500 businesses. Again, instead of being a detriment, those sometimes crazy fluctuations should serve the investor. Wild price action simply offers more chances to make purchases at a nice discount to approximate present value or, alternatively, to do some selling when prices become rather high relative to value.

Now, lets take a look at the same sort of numbers for Wells Fargo (WFC).

2006 WFC earnings per share = 2.47 (peak pre-crisis earnings)**

WFC at year-end 2006 = 35.56

P/E = 14.4

2013 WFC earnings per share = 3.89

WFC price = 51.63 (yesterday's close)

P/E = 13.3

% increase in earnings per share = 57.5%

Back in 2006, Wells Fargo seemed more expensive -- based upon on price to earnings -- than some other big banks. That Wells Fargo multiple of earnings may not look particularly high compared to the S&P 500, but it certainly was relatively high compared to some other big banks at that time.

Now, imagine buying Wells Fargo at that relatively expensive looking price back in 2006. Despite the slight P/E multiple contraction -- from 14.4 to 13.3 -- Wells Fargo's share price still went up more than the S&P 500 (and paid out more in dividends despite the dividend temporarily being cut).

The returns, while hardly spectacular -- in part, due to the at least somewhat expensive price back in 2006 -- contrast greatly with some other large financial institutions.
(Beyond those that got wiped out completely, of course.)

Unlike Wells Fargo's 57.5% increase in earning per share since 2006, a bunch of the big banks that are still around earn less than what they earned pre-crisis; in some cases, a small fraction. Much of this is due to dilution, of course. So, even if things go rather well for them from here, it's unlikely that their common shares will get to pre-crisis levels anytime soon.

Wells Fargo, with superior core economics, proved much more resilient than most others despite its own challenges and mistakes.

My point is that the importance of durable and superior economics is not only the upside; it's also the protection it provides on the down side. The financial system will, unfortunately, at some point down the road likely experience some real difficulties again. It seems, at least, wise to assume that's the case.

Some will try to protect against the downside by attempting to cleverly time the market. Good luck to those that do. That'd be one of those good ideas mostly in theory. A more practical approach is owning quality businesses and staying focused on price versus intrinsic worth. For those who decide owning shares of banks is worth the trouble (and I often wonder whether it really is considering alternatives), it's better to stick with quality. What looks cheap might have all kinds of downside. A reasonable valuation certainly matters, but it's just that, when it comes to investing in what are inherently very leveraged businesses, sometimes it's best to be skeptical of what appears on the surface to be a bargain.

In fact, I'm especially wary of financial institutions that look cheap during the good times. What seems like a seaworthy ship when the ocean is calm and the skies are blue can prove to be anything but once the storm clouds arrive.

Now, imagine having bought -- whether it was good fortune or otherwise -- shares of the larger financial institutions when they were selling at or near their lows. I mean, the very best banks as well as the weaker banks saw their stock prices collapse during the financial crisis. Most of the bigger banks -- at least those that survived the crisis a bit bruised but not broken -- would have generated very nice results for those who happened to buy near their lowest market prices.

In the real world, of course, most of us aren't going to consistently be able to buy shares when they are at or near their lows.

Most of the big banks were just generally NOT built such that the investor who, at least somewhat unfortunately, bought at pre-crisis prices came out okay. The fact that a bank like Wells Fargo stock would have produced good or better results, whether purchased pre-crisis or during the crisis, is an indication -- albeit a simplistic one -- of the very different risk versus reward profiles among the bigger banks.

A stock price that declines while per share intrinsic value remains roughly in tact is not, at least in the long run, a real problem. It may not be pleasant to look at the quoted prices for some time, but a stock that drops further below intrinsic value is an opportunity not a problem for the long-term investor. Besides, temporary paper losses are an inevitable part of the investing process. Those that can't stomach such things really shouldn't be exposed to the stock market.

On the other hand, a stock price that declines along with per share intrinsic value is a very real problem.

The quality banks -- usually those with higher return on assets and equity that also possess other important but less easy to measure characteristics -- should generally sell for a relative premium.

Margin of safety still matters but, with banks, it's usually better to avoid the bargain basement.

I'll stick with the quality stuff and, maybe, pay just a bit more if necessary.
(Though, as always, at what is still a nice discount to intrinsic value.)

It's worth mentioning that even the best bank's common shareholders won't necessarily be protected against another very serious financial collapse.

There's no rule that says the most recent financial crisis is as bad as it can get.

These businesses have unique risks even when they are run brilliantly.

Something to consider.

Adam

Long position in BRKb and WFC established at much lower than recent market prices

* The investor has control over what they are willing to pay for an asset they like if not much else. Yet t
he price paid provides only limited protection against permanent capital loss for some investments. In certain instances, the worst case valuation is either unclear or such that no price is low enough to protect against the worst possible outcomes. Naturally, the price paid should be comfortably below the estimated present per share intrinsic value. My preference is to calculate per share intrinsic value based upon lower end of an estimated range of future free cash flow, discounted appropriately. Confidence in those estimates should be very high and, well, warranted.  If not better to move onto something else. Never get caught up in a compelling story. That's a great way to pay too much for promise that may or may not be realized.
** The 2006 annual report showed diluted earnings per common share to be $ 2.49 per share but subsequent reports have it as $ 2.47.
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