Berkshire Hathaway (BRK.A 2.24%) (BRK.B 1.97%) CEO and legendary investor Warren Buffett has been a big supporter of banking giant Wells Fargo (WFC 2.95%) for many years. Berkshire has been a major Wells Fargo major shareholder for decades, claiming a 9.9% stake in the bank, the maximum it can own as an active investor.
Frankly, no other investor has been as supportive of Wells during its recent troubles as Buffett, who has gone so far as to say that he expects it to be one of the market's best-performing big bank stocks. Furthermore, it's also gotten pretty cheap over the past year, as the market has sent its shares -- along with those of most other banks -- falling sharply.
But is it a better buy than its biggest shareholder, Berkshire Hathaway? By most measures, Berkshire stock is also pretty cheap, and the diversified subsidiaries under its control generate massive amounts of cash flows, nor are they faced with the regulatory pressure and damaged reputation that could hinder Wells for years.
So that makes Berkshire the clear winner, right? Not so fast. Despite Wells' challenges, it is quite cheap, pays a very respectable dividend, and is far less troubled than the headlines make it seem. So let's make the bull and bear case for both before declaring a clear winner.
How Wells Fargo got here, and why it's appealing
Check out the latest Wells Fargo earnings call transcript.
It hasn't been a very good past couple of years for Wells Fargo. The aftermath of its fake accounts scandal has led to billions of dollars in fines, a significant weakening of its reputation in the eyes of banking consumers, and even the federal government forbidding it from growing its assets.
But like many other banks, Wells has delivered solid results and continues to prove highly profitable, even as management navigates this terrible period and works to fix its reputation. In the meantime, its stock has taken a beating and now trades for what many view as a bargain-bin valuation. At recent prices, Wells trades for 11.7 times trailing earnings and about 10 times expectations for 2019 earnings per share.
It also trades for just over 1.3 times book value. Here's some context on how cheap that is for Wells, which has by most measures one of the best-quality loan portfolios of any major commercial bank:
Wells Fargo stock has only traded for this low of a book in rare circumstances. At the beginning of the chart is the Global Financial Crisis, when the entire banking sector was viewed as one of the riskiest places to invest. After all, it was the mortgages these banks were issuing to just about anyone who could fog a mirror that played a critical role in bringing down the entire global financial system.
In the years that followed, the market quickly came back to Wells, which proved to have one of the strongest balance sheets. But even it wasn't immune to the lawsuits and fines in the aftermath of the Great Recession, something that caused its share price to fall multiple times as allegations were uncovered and fines and settlements were reached.
In late 2016, Wells' share price tumbled when the Consumer Financial Protection Bureau announced that the bank's employees had opened millions of unauthorized accounts in customers' names. That finding led to the ouster of CEO John Stumpf and would eventually lead to billions of dollars in fines and settlements. In addition, the Federal Reserve took the unprecedented step of prohibiting the bank from growing total assets any larger than it ended 2017 with, until it made "sufficient improvements."
Wells Fargo remains under a very dark cloud, and it could take it years to fully recover its reputation. Furthermore, the Fed may not allow it to start growing its assets for another year or even longer. We just don't know how long it will take to make regulators happy.
So how is Wells even close to being buy-worthy? In short, it's priced to be stuck in no-growth purgatory for the long term, and management is pulling some other levers to reward shareholders. Wells' 3.3% dividend yield is one of the strongest in banking, and its track record of raising the payout every year since emerging from the financial crisis, combined with strong financials, should lead to continued dividend growth from here.
Furthermore, management is aggressively buying back shares at current prices, with a $25 billion buyback approved and being implemented now. This is probably the best use of excess capital right now, since its shares are certainly cheap and it's not able to use that capital to fund loan growth, and it should result in some per-share growth in Wells' earnings.
And when the Fed finally takes the handcuffs off, I fully expect Wells to do very well for investors. Consumers are both fickle and forgetful. You only have to look at Bank of America's turnaround to see that. Wells' problems don't come close to BofA's troubles over the past decade.
The case for Berkshire: Excellent company at a reasonable valuation
In short, Berkshire is built on a foundation of dominant, cash-cow subsidiary businesses, many of which are relatively recession-resistant (such as its utility and insurance businesses) and have substantial barriers to competitive entry.
Furthermore, Berkshire's $200 billion stock portfolio is a significant source of cash; Wells Fargo alone will pay Berkshire $760 million in dividends in 2019, contributing to what is expected to be more than $4.6 billion in dividends that Berkshire's stock investments pay it this year.
And while it doesn't pay a dividend and isn't likely to implement one anytime soon, Buffet and investment managers Ted Weschler and Todd Combs continue to deliver market-beating returns with their investments of Berkshire's excess capital. Their efforts are a major reason Berkshire's book value per share has grown 22% over the past four reported quarters. At the same time, Berkshire's stock price has fallen by 6% over the past year and is down 10% from the 52-week high.
Put it all together, and Berkshire looks like a top-tier business, trading for one of the lowest premiums to its book value in years, while not having the limitations on its growth Wells faces and still counting Warren Buffett as its top executive.
A Buffett quote explains the winner
As Buffett famously said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
Between the two, Wells Fargo is the cheaper stock; from a pure valuation perspective it should win this comparison. But we aren't trying to answer the question of which is cheaper. After all, Wells should be the cheaper stock, considering the uphill battle it faces with the Fed and with public perception of its trustworthiness.
As things stand today, Wells sells for a wonderful price, but I can't say that it's a wonderful business. It certainly has been in the past, and I think the fundamentals are strong, and management is working to fix the broken culture in its retail operations and to restore faith with the public. But until that perception changes, you can't call Wells Fargo a great company.
Berkshire Hathaway, on the other hand, is a wonderful business by just about every definition, and it's trading at a fair price -- potentially a bargain -- based on its book value multiple and the likelihood that Buffett and his lieutenants will continue growing book value.
The bottom line is that investors usually do far better when they buy the wonderful business, so long as they're paying a fair price. Today, that's Berkshire Hathaway, though Wells' valuation and prospects to move beyond its current problems make it a surprisingly close call.