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Warren Buffett's Wells Fargo Problem

By Jordan Wathen - Feb 6, 2018 at 9:00PM

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Berkshire Hathaway is stuck with its shares of Wells Fargo.

Warren Buffett's Berkshire Hathaway (BRK.A -1.32%)(BRK.B -1.63%) owns a big slug of Wells Fargo & Company (WFC -0.15%), a company that is quickly becoming a big problem for the Omaha, Nebraska-based conglomerate.

A series of high-profile problems, including news that Wells Fargo opened 3.5 million fake accounts, and a recent discovery that the bank charged as many as 570,000 customers for car insurance they didn't need, culminated in an unprecedented move by the banking industry's chief regulator last Friday.

Fed limits Wells Fargo's growth

The U.S. Federal Reserve ordered Wells Fargo to cease its growth until "it sufficiently improves its governance and controls." The bank will have to cap its assets at roughly $2.0 trillion, which is where its balance sheet stood at the end of 2017, until it gets back on regulators' good side.

Warren Buffett at Berkshire's annual meeting.

Image source: The Motley Fool.

Even though Wells Fargo may be lagging the banking industry in terms of recent stock performance, its valuation baked in healthy deposit and loan growth. Prior to the announcement, Wells Fargo shares traded for more than two times tangible book value, a price that reflected its ability to retain earnings to support growth in deposits, loans, and of course, earnings. Wells Fargo has grown quickly in recent years, as assets have grown at a compounded annual rate of roughly 6.3% since the end of 2013, impressive for a bank that ranks among the largest by assets.

Not surprisingly, the market wasn't too pleased with news that Wells Fargo's growth would be capped for an indefinite period of time. Shares shed nearly 10% of their value on Monday. Berkshire Hathaway was one of the biggest losers, as its stake in the bank declined by approximately $2.7 billion in a single trading day. 

Stuck in a tough spot

While some investors find it easy to sell their stock and ask questions later, Buffett and Berkshire Hathaway don't have the same luxury. Because Berkshire Hathaway is a C-corporation, it pays full corporate taxes on any gain. Uncle Sam's share of Berkshire's profits makes selling its winning stocks a tough pill to swallow even after the Tax Cut and Jobs Act reduced the corporate tax rate from 35% to 21%.

I estimate that Berkshire Hathaway's stake in Wells Fargo was worth $27 billion at market close on Monday, but if Berkshire were to cash out, it would only receive about $23.8 billion in after-tax cash for its stake. The math behind my estimates is detailed in the table below.

Metric

Value

Value of Berkshire's stake in Wells Fargo (A)

$27.0 billion

Cost basis (B) 

$11.8 billion

Corporate tax rate (C)

21%

Unrealized gain (A-B)

$15.2 billion

Tax liability ((A-B)*C)

$3.2 billion

After-tax proceeds (A-((A-B)*C))

$23.8 billion

Data sources: WhaleWisdom.com, 2016 letter to Berkshire shareholders, Google Finance, author estimates.

These are, of course, estimates. In truth, my estimation of Berkshire's tax liability likely errs to the low side. Last year, Berkshire reduced its stake in Wells Fargo by roughly 7% at the request of regulators, likely selling off its shares with the highest cost basis to minimize its tax bill.

I estimated Berkshire's cost basis from Buffett's 2016 letter to shareholders, which was the last time Berkshire disclosed its cost basis for tax purposes, assuming that the 464.2 million Wells Fargo shares Berkshire owns today had the same average cost basis as the 500 million shares it owned at the end of 2016. At any rate, the difference is likely trivial, but the tax consequences of selling its stake in the bank are not.

What should Buffett do?

Warren Buffett and Charlie Munger may have publicly derided Wells Fargo for its scandals, but they've stopped short of actually selling a meaningful quantity of the shares Berkshire holds. I suspect the matter largely comes down to taxes. 

I estimate that for every $1 of Wells Fargo shares Berkshire owns, it would only receive about $0.88 in after-tax cash should it decide to sell its shares at Monday's closing price. To justify selling Berkshire's stake in the bank, Buffett would have to believe that $0.88 invested in another company can outperform $1 invested in Wells Fargo. This also assumes Buffett has a place to put $24 billion to work, which he doesn't, given that Berkshire Hathaway already has too much cash ($109 billion at the end of the third quarter).

Buffett and Berkshire Hathaway are simply stuck with Wells Fargo, for better or worse. 

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Stocks Mentioned

Wells Fargo & Company Stock Quote
Wells Fargo & Company
WFC
$40.18 (-0.15%) $0.06
Berkshire Hathaway Inc. Stock Quote
Berkshire Hathaway Inc.
BRK.A
$412,170.01 (-1.32%) $-5,529.99
Berkshire Hathaway Inc. Stock Quote
Berkshire Hathaway Inc.
BRK.B
$273.86 (-1.63%) $-4.54

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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