I recently came across a 2009 interview of Warren Buffett in which the billionaire explained his thoughts on Wells Fargo (NYSE:WFC), the second-largest holding in Berkshire Hathaway's (NYSE:BRK-A) (NYSE:BRK-B) stock portfolio. The interviewer teased out a number of interesting insights about the California-based bank that are just as relevant today as they were seven years ago.
1. Actions speak louder than words
If you listen to enough quarterly conference calls or read enough shareholder letters, you get the impression that all bankers follow the same script. They claim to have tons of capital, are focused on reducing expenses, and are prudent risk managers.
But the actions at very few major banks back up their words. We saw this during the financial crisis. Had you believed what bank executives said prior to 2008, you would have come away with the impression that Bank of America (NYSE:BAC) and Citigroup (NYSE:C) were poster children of prudence, when in reality, they had allowed their balance sheets to be tainted by toxic assets.
Wells Fargo was and is an exception to this. It says what it means and means what it says. According to Buffett:
The real insight you get about a banker is how they bank. You've got to see what they do and what they don't do. Their speeches don't make any difference. It's what they do and what they don't do. And what Wells Fargo didn't do is what defines their greatness.
2. Being contrarian is important
Why did Wells Fargo thrive as a result of the financial crisis while Bank of America and Citigroup were lucky just to have survived it? The answer is that Wells Fargo hadn't blindly chased the subprime mortgage lending fad by continuously reducing its credit standards in order to originate more loans.
This seems obvious in hindsight, but it was a difficult decision at the time because it meant that Wells Fargo had to consciously accept that it would lose market share to less-prudent peers such as Bank of America and Citigroup. While the latter were revving up subprime mortgage originations by offering mortgages with teaser interest rates and essentially no income or asset requirements, Wells Fargo was going in the opposite direction.
As Wells Fargo's chairman and CEO noted in their 2007 letter to shareholders:
Because of our prudent lending to customers with less than prime credit and our decision not to make negative amortization loans, we estimate we lost between two and four percent in mortgage origination market share from 2004 to 2006. That translates into losing between $60 billion and $120 billion in mortgage originations in 2006 alone. We're glad we did. Such lending would have been economically unsound and not right for many borrowers
This is music to Buffett's ears, as he noted in the 2009 interview with Fortune:
Those guys have gone their own way. That doesn't mean that everything they've done has been right. But they've never felt compelled to do anything because other banks were doing it, and that's how banks get in trouble, when they say, "Everybody else is doing it, why shouldn't I?"
3. Banking is good business, unless you do dumb things
Here's the thing about banking: While it's easy to grow a bank's revenue, it's much harder to generate consistent profitability through all stages of the credit cycle. Banks sell money by making loans, and who doesn't want a little extra money if the price (i.e., the interest rate) is right?
The trick for any bank is to balance the short-term desire to grow revenue against the long-term impact of doing so imprudently -- that is, by dropping credit standards in order to boost loan originations. As Buffett said:
In the end banking is a very good business unless you do dumb things. You get your money extraordinarily cheap and you don't have to do dumb things. But periodically banks do it, and they do it as a flock, like international loans in the 80s. You don't have to be a rocket scientist when your raw material cost is less than 1.5%.
4. The key to Wells Fargo's future
Wells Fargo has always been a well-run bank, avoiding losses in the last three banking downturns, each of which nearly caused Bank of America and Citigroup to fail. Its strengths were nevertheless bolstered by the philosophy of Dick Kovacevich, who emerged as chairman and CEO after Wells Fargo's 1998 merger with Minneapolis-based Norwest.
Kovacevich thought of banks as retail stores, not branches. On top of Wells Fargo's long history of prudence, he grafted a sales-oriented focus that begins with acquiring checking accounts -- the gateway drug, if you will, of banking products. This has allowed the $1.8 trillion bank to not only gather up a copious amount of low-cost deposits that it uses to fund higher-yielding loans, but it also has powered Wells Fargo's ability to sell its average client more than six of its financial products.
These are the twin pillars of the bank's success, as Buffett alluded to in 2009:
The key to the future of Wells Fargo is continuing to get the money in at very low costs, selling all kinds of services to their customer and having spreads like nobody else has.
5. What does Buffett pay attention to?
Investors tend to value bank stocks differently than they value other stocks. For most companies, investors look at the price-to-earnings ratio, which compares how much a company earns on a per-share basis to how much the company's stock costs. The lower the ratio, the cheaper the stock.
Bank investors look instead to the price-to-book-value ratio or the price-to-tangible-book-value ratio. These measure how much a bank's stock costs relative to the total value of its underlying assets. For example, Bank of America's stock currently costs $13.94 a share, while its tangible book value per share is $16.17. Because the former is below the latter, analysts (including me) generally consider Bank of America's stock to be cheap.
Buffett's insight is that bank stocks shouldn't be treated differently than other stocks, at least when it comes to valuation.
What I pay attention to is earning power. Coca-Cola has no tangible common equity. But they've got huge earning power. And Wells Fargo ... you can't take away Wells' customer base. It grows quarter by quarter. And what you make money off of is customers. And you make money on customers by having a helluva spread on assets and not doing anything really dumb. And that's what they do.