Friday, September 5, 2014

Risk and Reward: Wells Fargo, U.S. Bancorp, and BofA

From this CNBC Interview with Warren Buffett back in 2012:

"The profitability of banking is a function of two items. Return on assets and assets to equity.

And return on assets is not going to go up particularly. USB has done the very best on that. They're at about 1.7 percent. Wells is between 1.4 and 1.5 percent. But most banks are lower. Now, if you have 20 times leverage and you're getting 1.5 percent on assets, you're making 30 percent on equity.

And that was not lost on people a few years back. And they pushed balance sheets..."

He also added this:

"Banks were —banks were earning 25 percent on tangible equity not so many years ago. And really, that's kind of a crazy number. You know, for a basic semi-commodity business, you really don't want to allow that." 

and

"...people got to push and push it and push it, and then the government says, 'Listen, we got a vested interest in this. You're using our credit, in effect, and if you want to play, you're only going to have 10-to-1, or some number like that.' So the returns on banks have come down. It's still a good business."

Buffett on Banks: CNBC Interview

One limited way , but I think meaningful, compare the relative strength of banks is to look at what happened to these businesses (and, ultimately, their stocks) as a result of the financial crisis.

Let's say Wells Fargo's (WFC) stock was purchased at its pre-crisis peak price. As the crisis unfolded, that no doubt didn't feel like a brilliant move.

Those who did buy at that worst possible time pre-crisis would actually still have a rather solid (~ 60%) if not spectacular gain at this point (though some rather wild price action, to say the least, had to be tolerated). Stock performance has not been dependent on the shares trading at some speculative (high) price. Normalized per share earning power has increased substantially and the stock, give or take, reflects it.

So it's been mostly about business performance over that time. The acquisition of Wachovia resulted in additional shares outstanding but seems to have worked out just fine. The dilution that did occur as a result of capital that was raised wasn't without a real cost to continuing shareholders. Not all dilution is created equal. How market price compares to intrinsic value, as always, matters a bunch. The shares, like many banks at the time, were selling at a meaningful discount to value. So that was less than ideal but, overall, the bank's business and stock have performed rather well. Not phenomenal investment results if bought at the pre-crisis high but, then again, value conscious long-term oriented investors should have been able to buy at more attractive valuations.

At the other extreme, not surprisingly, those who bought at the lowest price during the crisis would have huge gains -- several hundred percent, in fact.

The results were mostly similar for U.S. Bancorp (USB).

In other words, the range of outcomes was from reasonably good to very good; from gains to even greater gains. A decent result even if the stock wasn't bought brilliantly. Realistically, what would happen in the real world to someone investing long-term in these banks is they'd have made purchases somewhere between these two extremes. That would have produced a very good result indeed. The focus should be on the strength of a banking franchise, price versus value, and long-term effects instead of near-term price action. The point being that there's no need to get the timing right nor is it possible to reliably do so.

Attempts to time things perfectly leads to missed opportunities.

What these banks have in common is the robustness of their core economics. They're better able to absorb losses during the tough times and produce above average normalized returns.

The same cannot be said for Bank of America (BAC).

Lets say someone similarly bought Bank of America's stock at its pre-crisis peak. Those who took that action would still now need the stock to more than triple to get back to even.

At the other extreme, those who bought at the lowest possible price would be up several hundred percent. So the best case was much like Wells and U.S. Bancorp.

In this case, the range of outcomes went from very bad to very good; from big losses to big gains. Those who had the misfortune of buying at the peak will likely have to wait until something like 2025 (and maybe much later) for per share intrinsic value to equal what was paid pre-crisis.*

By the time BofA's stock finally reaches those pre-crisis levels, the buyers of Wells at the somewhat expensive pre-crisis peak should still end up with a more than respectable annualized total return. That's under the scenario of having bought at the worst possible pre-crisis price! Obviously, it wasn't difficult to buy at much more attractive prices if the focus was on long-term effects instead of scary headlines and awful near-term stock price action.

Getting a good result investing in BofA was highly dependent on buying brilliantly; not so for Wells and U.S. Bancorp.

I'm certainly not downplaying how serious the crisis was. Without certain policies, and decisive actions, even the very high quality banks would not produced these investment outcomes. This is why investing in the common stocks of banks can be far more tricky than many other common stocks. Even when run competently these are inherently leveraged institutions that depend on system stability and the inevitable associated risks. These businesses are incredibly complex.

There are a number of more straightforward ways to get investment results. Sometimes I wonder whether it's worth all the additional work that's required.

Keep in mind that Wells and U.S. Bancorp were the "expensive" stocks pre-crisis. They were selling for roughly 14-15x earnings at the time.

BofA is the one that looked cheap at more like 11-12x earnings before the financial crisis.

The real emphasis here is on per share earnings since, there's no way to know when stock prices will reflect something close to per share intrnsic value. Wells has increased its per share earnings power meaningfully compared to pre-crisis peak earnings; U.S. Bancorp earnings has increased more modestly.

The key thing here is that, at least with these two banks, we are at least talking about increases to per share earnings.

In contrast, BofA is struggling to earn even one third as much as it did pre-crisis. Much of this comes down to the dilution that occurred as a result of necessary capital raising. The fact that they were forced to raise capital when their stock price was very low didn't help at all, of course. It did great damage to their per share earning power. Also, the acquisition of Countrywide has been incredibly expensive. There are other factors including reduced leverage and the regulatory environment more generally.

In any case, Wells Fargo and U.S. Bancorp are, for many reasons, just vastly more capable of generating an attractive return on assets and equity. As Buffett points out above that's what matters in the long run if at least a reasonable price is paid in the first place.

A bank with a 1.5 percent return on assets compared to one with, let's say, 1 percent return on assets may not seem like a big deal but it is. At 10x leverage that'd be 15% return on equity (ROE) versus 10%.

- ROE for Wells currently sits at 13.4%

- ROE for U.S. Bancorp is 15.1%

- ROE for BofA is in the single digits, though it should improve somewhat as earning power normalizes

So Wells and U.S. Bancorp continue to have big economic advantages over BofA. Compounded over longer time frames, if persistent, these superior economics will matter a great deal in terms of investment results.

It's not just about offense.

There's a defensive element to consider.

Wells Fargo, for example, should be able to roughly absorb an extra $ 10 billion or so of losses per year on its current asset base because of its ROE advantage. The not so good times will inevitably return -- likely under very different circumstances -- and a quality bank should be built to comfortably handle significant economic and financial stress.

So, for the better banks, not only are overall returns higher on a normalized basis, the risk of permanent capital loss is reduced because of a greater ability to absorb losses with earnings over time instead of cutting into capital. Most of the damage that was done during the crisis, for common shareholders, was due to costly capital raising (i.e. when the capital is raised at a price that is well below per share intrinsic value based on normalized earning).

Wells and U.S. Bancorp have been and mostly remain vastly superior in terms of the capacity to protect against downside.** 

In the end this makes for a very different risk versus reward profile.

So watch out for the "cheap" banks or, at least, those that appear to be cheap on the surface.

For now, my view is that the risk-reward profile still appears more challenging -- more risk for less reward. To me, BofA's risk-reward profile at the very least calls for a bigger margin of safety.
(There are many investment situations where no margin of safety is sufficient considering the investment specific risks; when the expected worst case outcome is intolerable.) 

BofA may yet develop more favorable core economics over time and the risk-reward profile may change. It will be interesting to watch as things evolve over time.

Much of modern finance theory still assumes that more risk must be taken to achieve greater reward. In fact, the formulas found in prevailing theory really only allow for a positive correlation to exist between risk and reward. So it's not just words. Of course, many times risk and reward must necessarily be correlated in a positive manner.

Other times, they're not correlated in such a manner.

The significance of this is sometimes underappreciated.

Risk and reward can be positively correlated; it's just not necessarily so.

As noted above, a bank can be both less risky and offer more potential reward. The same can be true for other businesses. Also, consider the impact of paying a lower price for a particular asset. Well, the lower price will simultaneously reduce the risk of permanent capital loss while increasing the potential reward.***

At least some of the prevailing modern finance theory seems deeply flawed.

Adam

Long positions in WFC, USB, and BAC established at much lower than recent prices. WFC and USB are long-term investments; BAC is likely much less so.

* That's if there's not another costly financial crisis. No bank -- not even the very best -- is immune to the financial system completely collapsing. Of course, if that were to happen, I'm guessing many of us will be focused on more pressing things than stock prices.
** Pre-tax pre-provision profit is a key consideration. It indicates how much in terms of losses a bank can absorb through earnings over time before cutting into capital. Asset quality, capital levels, stable funding and liquidity also naturally matters a bunch. 
*** Here's how Warren Buffett explained the correlation between risk and reward in The Superinvestors of Graham-and-Doddsville:

"I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward!

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.


One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy. 

Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it's riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying $400 million for $80 million..."
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