You don't hear too many good things about banks these days, which is why those of us who traveled to the Berkshire Hathaway (NYSE:BRK-A) shareholder meeting over the weekend were taken aback when Warren Buffett gave the largest endorsement of a bank -- heck, of any company -- we've ever heard.
Recalling the days in early March when Wells Fargo (NYSE:WFC) slipped below $9 a share, Buffett -- without the slightest hesitation -- stated, "If I had to put all of my net worth into stock, that would be the stock."
Whoa!
Now, before you sell all your possessions and plow your net worth into Wells Fargo, realize that Buffett's comment was solely in respect to shares trading for less than $9 -- 63% below today's price. The incredible irony is that Buffett's net worth actually exceeded Wells Fargo's entire market cap at those depressed levels. (We'll let that inconsistency in his argument pass on the basis of sheer awesomeness.)
In any event, two big questions surround this rousing endorsement:
- What does Buffett see in Wells Fargo that the rest of the market doesn't?
- Are there any holes in his argument? Betting against Buffett is usually fruitless, but it's also dangerous to blindly chase anyone while oblivious to potential risks.
Here's a rundown of the good, bad, and ugly that Buffett has focused on in the past.
You can't touch this
Buffett recently told Fortune magazine that Wells Fargo's secret to success is "low-cost deposits and a lot of ancillary income coming in from their customer base."
Through a combination of reputational superiority and a sales force that's relentless about cross-selling new bank products, Wells Fargo has created a deposit base that's significantly cheaper than its competitors. Looking at 12-month CD rates, the difference between the rates at which Wells Fargo can raise deposits compared to those of its competitors is staggering:
|
Bank |
Current 12-Month CD Rate |
|---|---|
|
Wells Fargo |
1.06% |
|
Bank of America (NYSE:BAC) |
2% |
|
Citigroup (NYSE:C) |
2.25% |
|
JPMorgan Chase (NYSE:JPM) |
1.75% |
*As of May 4, 2009.
Most importantly, that low-cost deposit base translates directly into earnings power. Looking at the net-interest margin -- the difference between a bank's interest income and interest expense -- Wells Fargo is in a league of its own:
|
Bank |
2008 Net Interest Margin |
|---|---|
|
Wells Fargo |
4.8% |
|
Bank of America |
3% |
|
Citigroup |
3.1% |
|
JPMorgan Chase |
2.9% |
Smarter than your average bank
Of course, a low-cost deposit bank means squat if you invest those deposits in firecrackers and lottery tickets. Bear Stearns and Lehman Brothers had exceptionally low costs of capital from exploiting the overnight repo market. How'd that end up working out?
It's hardly unscathed, but Wells Fargo nonetheless avoided most of the utterly insane lending practices that characterized the boom years. Rumor has it that the bank would often verify people's income before loaning money. Ingenious!
Nonetheless, one big area investors fret over is the book of assets Wells Fargo inherited from the Wachovia acquisition. Wachovia ultimately blew up because of its own 2006 acquisition of Golden West, which overdosed on variable-rate loans underwritten with standards that could make Bernie Madoff look like a wuss.
However, much of that risk has been purged from Wells' books, thanks to a 39% writedown of the high-risk portion of Wachovia's portfolio the day the merger closed. That's an insanely high number at which to discount a loan portfolio, and one that likely includes a nice margin of safety to protect Wells Fargo going forward. As Buffett recently noted, "...my guess is that the option ARMs will work out about as [Wells Fargo] guessed."
Great! So what's the catch?
All touting aside, are there any holes in Buffett's Wells Fargo love affair? Yes, one -- and it's actually a hole the Oracle himself pointed out a few months ago.
"The only worry," Buffet said back in March, "is that the government will force [banks] to sell shares at some terribly low price."
Well, start worrying. The Wall Street Journal reports that Wells will be among the handful of banks forced to recapitalize when the Treasury announces its stress test results this week. It's entirely unclear how much Wells will have to raise, but some estimates have tagged the number as high as $50 billion. Raising capital at low levels would be destructive for shareholders -- perhaps substantially so, if the Treasury overreacts in an attempt to cover its butt. And it probably will.
Bottom line
Just because Buffett seems fired up about a company's potential doesn't necessarily mean you should dive in headfirst. As we saw with Goldman Sachs (NYSE:GS) and General Electric (NYSE:GE), he can get terms you and I couldn't dream about.
Even so, it's hard to look past this endorsement without acknowledging that good things come out of bad markets. When the world's most successful investor says he'd be comfortable making moves so bold, they'd normally classified as financial suicide, maybe it's time to listen.
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