Warren Buffett’s favorite bank is now once again the most valuable in the world.
As the WSJ reported this morning, San Francisco-based Wells Fargo & Co., recently surpassed Industrial & Commercial Bank of China Ltd. as the lender with the largest market value in the world (note: Wells Fargo has wrestled with ICBC for the top spot for years, first claiming the most-valuable spot in 2013). As of this morning, Wells Fargo’s market cap was $299 billion – $11 billion more than ICBC and $42 billion and $120 billion more than J.P. Morgan Chase & Co. and Citigroup Inc., respectively.
As the WSJ reports:
Why is Wells Fargo valued the way it is?
Wells Fargo’s market value surpasses those of all peers thanks largely to its relatively simple business, which doesn’t rely on many complex derivatives or risky trades using borrowed money… [T]he very traits that were considered a weakness a generation ago are now regarded as a strength. The bank has largely eschewed investment banking and trading income, which has endeared it to regulators. That means the bank has fewer capital demands, which lowers its lending costs and increases its ability to pay dividends and buy back shares.
Wells Fargo’s most recent valuation seems to point to the relative strength of the U.S. economy, as China is racked by stock-market gyrations and Europe labors with existential questions about the eurozone.
Of course, Buffett would argue that the bank’s most recent valuation points to the strength of Wells Fargo versus all of its competitors.
Buffett first bought Wells Fargo stock for Berkshire Hathaway in 1989 and 1990. During that time, in the midst of the savings and loan crisis, real estate prices were collapsing and lenders were taking a beating on their balance sheets and in the markets.
Buffett described the Wells Fargo transaction in his 1990 letter to shareholders:
Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled — often on the heels of managerial assurances that all was well — investors understandably concluded that no bank’s numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.
So Buffett first bought the stock cheap – 5x earnings – but he’s been adding to the position ever since (most recently in 1Q 2015). Buffett said in 2012, “I like Wells better than anything by far. We bought Wells this year. We’ve bought Wells month after month… for a lot of years. I like loading up on the one I like best.”
Berkshire Hathaway – which owns a little over 9% of the company – is Wells Fargo’s largest shareholder and, in 2012, Wells Fargo became Berkshire’s largest outside investment.
Today, Berkshire’s stake in Wells Fargo are worth over $27 billion – that’s 1.7x more than Berkshire’s stake in Coca Cola and over 2x more than its stake in IBM, Berkshire’s next two largest equity holdings!
So, even after 25 years, why does Buffett like Wells Fargo so much? I can point to three reasons.
Warren Buffett loves his economic moats, and Wells Fargo has got a wide one. While many of Wells Fargo’s competitors on Wall Street cater to the top 1%, Wells make more than half of its profits from “Main Street” style banking.
Wells Fargo excels at retail banking – mortgage lending, credit cards, and the mundane business of accepting deposits and servicing checking accounts.
As a result, Wells is the top mortgage lender and the top auto loan lender in the United States and serves one out of every three households in the country. Its focus on its core retail lending platform has also helped the company become one of the top “relationship” bankers in the industry, and allows the company plenty of opportunities to cross-sell: the average household that banks with Wells Fargo has more than six different products with the bank, including deposit accounts, brokerage accounts, loans, and insurance products.
Wells Fargo’s size is also a great barrier for the company. At the end of Q1 2015, Wells Fargo’s deposit base was $1.3 trillion, putting the company in a close second place behind J.P. Morgan’s $1.4 trillion. By way of comparison, the top 4 U.S. banks in terms of deposits (J.P. Morgan, Wells Fargo, BofA, and Citigroup) hold 45% of all of total deposits, with the fifth largest (U.S. Bancorp) holding only $0.3 trillion.
Buffett also wrote this in the 1990 shareholder letter:
The banking business is no favorite of ours. When assets are twenty times equity — a common ratio in this industry — mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the “institutional imperative:” the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.
Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly managed bank at a “cheap” price. Instead, our only interest is in buying into well-managed banks at fair prices.
With Wells Fargo, we think we have obtained the best managers in the business.
Wells Fargo is also very conservative in its business strategy. The bank only uses 10% the amount of derivatives that the other “Big 4” banks use and is relatively small in trading.
Perhaps more importantly, Wells Fargo has been very smart in its core lending operations and makes less risky – and less bad – loans than its competitors, which has allowed it to weather the financial storms of the past 25 years better than the other large banks. Wells Fargo avoided many of the major mortgage losses of peers during the 2008-2009 credit crisis and its quarterly charge off rate never exceeded 3% over the last decade, with the bank also managing to strongly grow book value per share before and after the financial crisis.
Wells Fargo’s business model is incredibly simple. Borrow money in the form of deposits at very low rates and lend that money out at higher rates. The margin between these two rates is called the interest rate spread.
Wells Fargo’s is spread is bigger than its competitors because it get its deposits cheaper than everyone else. This is largely the result of its volume of deposits, close to 78% of which are from small retail investors, which tend to be fairly sticky (especially with 6 different products open).
By contrast, competitors such as Bank of America and J.P. Morgan have a substantially greater portion of their funding from debt.
In the banking industry, loyal customers translate into cheap sources of capital. A family with a mortgage, a checking account, and a brokerage account is less likely to leave to chase higher CD rates, for example. As a result, Wells excels at making money the old-fashioned way, on the spread between deposit and lending rates. (Think: Borrow cheap, lend dear.) Its average cost of funds in the fourth quarter was just over 1.5%, compared with an industry average of 2.1%. “If you’re the low-cost producer in any business – and money is your raw material in banking – you’ve got a hell of an edge,” says Buffett.”If you have a half-point edge… half a point on $1 trillion is $5 billion a year.”
This low cost funding source has allowed Wells Fargo to earn above average returns on assets deployed, without needing to take significant risk in the deployment of funds to generate returns.
Wells Fargo’s decision to focus on Main Street instead of derivatives and trading has also aided its ROA in a different way.
On Monday, July 22nd, the Federal Reserve told eight of the country’s biggest banks how much extra capital they would need to set aside to protect against losses. Of the six largest banks, Wells Fargo, the fourth largest by assets, has the smallest surcharge – 2% – compared with 4.5% at J.P. Morgan and 3% at Bank of America and Goldman Sachs, who rely much more on short-term market financing – the type that can vanish in a crisis – instead of deposits.
Wells Fargo in Buffett’s Own Words
The best summary of the above three points of course comes from Warren Buffett himself, in this interview with Fortune magazine:
Fortune: How is Wells Fargo unique?
Warren Buffett: It’s sort of hard to imagine a business that large being unique. You’d think they’d need to be like any other bank by the time they got to that size. 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?”
[…] 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 1-1/2%. So I know that you can have a model that works fine and Wells has come closer to doing that right than any other big bank by some margin. They get their money cheaper than anybody else. We’re the low-cost producer at Geico in auto insurance among big companies. And when you’re the low-cost producer – whether it’s copper, or in banking – it’s huge.
Then on top of that, they’re smart on the asset side. They stayed out of most of the big trouble areas. Now, even if you’re getting 20% down payments on houses, if the other guy did enough dumb things, the house prices can fall to where you get hurt some. But they were not out there doing option ARMs and all these crazy things.
And they do not have all kinds of time bombs around. Wells will lose some money. There’s no question about that. And they’ll lose more than the normal amount of money. Now, if they were getting their money at a percentage point higher, that would be $10 billion of difference there. But they’ve got the secret to both growth, low-cost deposits and a lot of ancillary income coming in from their customer base.