For several quarters now, Berkshire Hathaway has been trimming its position in Wells Fargo (NYSE:WFC), a stock once beloved by chairman and CEO Warren Buffett. At the end of 2019, Berkshire owned more than 323 million shares of the bank, valued at roughly $17.4 billion. After the third quarter of 2020, it had whittled its position down to roughly 127 million shares, a stake that would currently be worth about $4.4 billion.
With Berkshire Hathaway apparently losing confidence in the bank, is Wells Fargo still a Warren Buffett stock? It's complicated.
Buffett's investment criteria?
It's hard to really know what's going on inside Buffett's mind. But at his core, he's a value investor, meaning he generally looks for stocks that seem underpriced relative to their intrinsic value.
Buffett learned his ways from Benjamin Graham, the father of value investing, who quite literally taught Buffett during his time at Columbia Business School. Graham's approach uses seven criteria to evaluate a stock:
1. Adequate size of the enterprise
2. A sufficiently strong financial condition
3. Earnings stability
4. Dividend record
5. Earnings growth
6. Moderate price/earnings (P/E) ratio
7. Moderate price-to-book ratio.
Because there is a lot to cover, I think we can start by checking off the first three points -- Wells Fargo meets them. The remaining four are where the complexity lies.
Earnings growth and dividend yield
I'm going to evaluate Wells Fargo using results from 2019 as well as 2020. While the pandemic is hopefully a once-in-a-lifetime event, banks typically go through a down cycle once a decade, and Wells Fargo's inability to meet some criteria is partially a function of its own problems -- many other banks still could have met Graham's criteria despite coping with the pandemic and the recession.
Well before the pandemic, the phony-accounts scandal hurt Wells Fargo deeply. Not only did regulators levy heavy fines and issue multiple consent orders against the bank because of its misdeeds, but the Federal Reserve also limited the bank to $1.95 trillion in assets. Wells was already approaching that cap, and the pandemic only made matters worse: High credit costs and low interest rates greatly reduced profitability.
All of this could lead investors to assume that Wells Fargo is failing to meet Graham's requirement for earnings growth and dividend yield. In some regards, they'd be right. But again, it's complicated.
For dividend yield, Graham looked for companies that made uninterrupted payments for at least 20 years. Wells Fargo has paid some kind of dividend every year, but has now had significant dividend cuts twice in the last 20 years, trimming its dividend sharply in 2009 during the Great Recession and cutting its dividend 80% in 2020. However, following the Great Recession, Wells Fargo was able to quickly recover and boost its payouts back above where they had been beforehand. And in 2020, the bank only had to cut its dividend because of restrictions put in place by the Federal Reserve. With $25 billion in excess capital, Wells Fargo certainly could have kept distributing money to shareholders.
On the earnings front, Graham used an interesting method to evaluate whether a company's growth was sufficient. He looked back over a 10-year period and compared earnings in the first three years of it to the most recent three years. His criterion was that the latter should be at least 33% higher than the former.
Across a more normal decade of 2010 through 2019, Wells Fargo easily meets this standard. Earnings per common share from 2010 to 2012 add up to $8.48. Earnings per common share from 2017 to 2019 were $12.53 -- 48% higher.
Shift one year forward and include pandemic-punished 2020, and it's a far different story. Wells Fargo's earnings per common share from 2011 to 2013 were $10.20.While we don't have Wells Fargo's earnings from Q4 2020 yet, analysts on average are projecting earnings per share of $0.33 in 2020, and the highest individual estimate is $0.58. Even if we use that most optimistic figure, Wells Fargo's total EPS for the 2018 to 2020 period would amount to $8.97 -- a decline from its 2011-2013 earnings.
P/E and price-to-tangible-book ratio
In terms of P/E ratio, Graham believed that a value stock's "current price should not be more than 15 times average earnings of the past three years." For the price-to-tangible-book-value ratio -- which we are using instead of price-to-book because it's a better indicator of a bank's intrinsic value -- Graham says the current price should not exceed 1.5 times the last reported value. Together, Graham believed that a company's P/E multiplied by its price-to-book ratio (or in our case, the price-to-tangible-book ratio), should not exceed 22.5.
From 2017 through 2019, Wells Fargo had average earnings per common share of $4.16. Looking at 2018 through 2020 and using the $0.58 earnings per share estimate for 2020, average earnings for the period are $2.99. So, with Wells Fargo at $53.80 per share on the last day of 2019, the bank was valued at 12.93 times the average earnings of the prior three years ($53.80/$4.16). Trading at $29.75 on the last day of 2020, Wells Fargo was valued at 9.95 times the average earnings of the last three years ($29.75/$2.99). So Wells Fargo would clear Graham's P/E threshold requirements for a value stock for both periods.
On price-to-tangible-book-value ratio, Wells Fargo, despite its struggles, was still valued at around 1.61 at the end of 2019. However, with shares recently above $33, the bank traded at a ratio of around 1.03 -- by far the lowest valuation of any bank currently in Berkshire Hathaway's portfolio.
Using 2019 numbers, Wells Fargo's P/E multiplied by its price-to-tangible-book value was 20.7 (12.93 x 1.6). Using 2020 numbers, it was just 10.3 (9.95 x 1.04). Both are below Graham's 22.5 threshold.
Is Wells Fargo still a Buffett bank?
Whether one uses the 2019 or 2020 numbers, Wells Fargo doesn't technically meet all seven of Graham's value stock requirements, depending on how you view the dividend yield. Still, I think there's a strong argument to be made that Wells Fargo was a value stock at the end of 2019, and is even more so now. The bank has an incredibly low valuation relative to its peers and has likely absorbed the brunt of its punishment from the phony-accounts scandal.
However, Buffett had already been curbing his position in Wells Fargo before the pandemic, likely due to his displeasure with the phony-accounts scandal and the way the bank had responded to it. The Oracle of Omaha only accelerated his sell-off as the pandemic has progressed, and as he's gotten more selective on bank stocks in general.
Because of this, it's hard to believe Buffett would change his mind in terms of owning the stock. "When we sell something, very often it's going to be our entire stake: We don't trim positions," he said at Berkshire's virtual investor day in May. Would Buffett sell off a huge portion of his Wells Fargo stake so he could simply buy it back months later? Seems doubtful. But could Wells Fargo be viewed as a Buffett stock right now based on his and Graham's core value investing principles? Quite possibly.