Reading one of Inside Value pick Berkshire Hathaway's
The banking biz background
Despite Berkshire's past and current holdings in banks such as M&T Bank, Suntrust
Generally, a good insurer can generate a very low or positive cost of capital. In comparison, a good bank generally has a higher cost of capital than a good insurer. As a result, in order to generate adequate returns, banks tend to run at greater leverage ratios. For example, life insurer Torchmark
Buffett noted that this leverage magnifies the effect management has on a bank's results, and decided that he was only willing to invest in banks whose management teams had unquestionable integrity.
A cut above
At Wells Fargo, Buffett found an exemplary management team in Carl Reichardt and Paul Hazen. Buffett observed that this dynamic duo complemented each others strengths and weaknesses in a mutually beneficial relationship, kept tight reins on headcount and operating costs, and stuck to their circles of competence.
As a result, Wells Fargo was a stellar performer, with more than 20% returns on equity and 1.25% returns on assets. Buffett also noted that Wells Fargo executives were the most sought-after in the industry, but recruiters were unsuccessful in getting them to defect to other banks.
Blood in the street
1990 was an absolute bloodbath for the banking industry. M&T Bank reported in its 1990 annual report that the FDIC estimated that 300-400 banks with $95-165 billion in assets would go belly-up in the next couple of years. Wells Fargo, as a real estate lender with West Coast exposure, was considered extremely vulnerable to plummeting real estate values; it was often mentioned as a bankruptcy candidate.
As a result, Wells Fargo stock plummeted 50%. When Buffett scooped up the majority of his at-the-time 10% stake in Wells Fargo, shares were trading at a ridiculously low three times pre-tax earnings and five times net income. Today, Wells Fargo trades at 13 times net income. In hindsight, it's clear that based on traditional metrics, Wells Fargo was cheap when Buffett bought it. The Oracle of Omaha simply ignored the conventional wisdom that Wells Fargo was a sitting duck, and foresaw that the bank would survive and thrive for years to come.
Margin of safety
Buffett's belief in Wells Fargo's survival is clearly explained in Berkshire's 1990 annual report. He figured that Wells Fargo earned $1 billion pre-tax, including $300 million in annual loan loss provisions. He then stress-tested the company by assuming a whopping 10% of the bank's $48 billion in loans defaulted, resulting in each of those loans taking 30% (including foregone interest) principal losses.
In the case of these extremely dire circumstances, Wells Fargo would take a $1.4 billion pre-tax loss ($48 billion times 10% times 30%), which would be nearly offset by the $1 billion pre-tax income and $300 million in loan loss provisions. (That's almost exactly what actually happened.) Thus, Buffett figured that even in an extremely adverse environment, Wells Fargo would still be nearly breaking even. In normal environments, it followed, the bank would return to its excellent form.
With the benefit of perfect hindsight, it's clear that Buffett was able to seize a rare chance to buy one of the best banks in the world at a throwaway price, largely because others were too fearful to realize that Wells Fargo's survival and strength were never in doubt. If the market's current hysteria over subprime troubles presents us with a similar opportunity, here's hoping Fools will follow in Buffett's footsteps.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Fool's disclosure policy has a crystal ball you can borrow.