Wells Fargo is Cheap!

OK, so in my last post I commented that WFC is a great bank but is fully valued.  This thought stuck to my mind over the weekend.  Sometimes when I write something (whether blog or email), what I write bounces around in my head and I have second thoughts about it long after I hit the "send" or "publish" button.

I was wondering, is it really fully valued?  If it is fully valued, then why does Buffett keep buying WFC stock?  He has been buying even before the crisis when the storm clouds were very visible, and even now after financial stocks have rallied a lot.

Why I Said It's Fully Valued
First, let's just look at why I think (or thought) WFC is fully valued.  This valuation approach is the same as how people look at other banks like JPM, BAC and others.

But anyway, here it goes.  Below is the ROA and ROE of WFC since 1997.

               ROA       ROE
1997      1.37%      12.81%
1998      1.04%        9.86%
1999      1.85%      17.66%
2000      1.81%      18.53%
2001      1.40%      14.94%
2002      1.77%      19.60%
2003      1.64%      19.36%
2004      1.71%      19.56%
2005      1.72%      19.57%
2006      1.73%      19.52%
2007      1.55%      17.12%
2008      0.44%        4.79%
2009      0.97%        9.88%
2010      1.01%      10.33%
2011      1.25%      11.93%
2012      1.41%      12.95%

Here are the averages for the various time periods:

                              ROA             ROE
Since 1997             1.4%              15.0%
Last 10 years          1.3%              14.5%
Last 5 years            1.0%              10.0%

WFC has a decent, consistent record.  One way to look at it is that WFC in normal times can earn 1.5% ROA and a 15% ROE or something like that.  With a 15% ROE, WFC can easily be worth 1.5x book value.

As of the end of 2012, BPS of WFC was $27.64/share.  1.5x that is $41.46/share.   At $35/share, WFC seems to be trading at a 15% or so discount to what it's worth; not so exciting.  Of course, it is still a good, solid holding.  If it's worth 1.5x book and the book keeps growing, WFC can obviously still be a great stock to own.

So one way to look at it is that although it may not be trading at a discount to what we think it's worth, it's still a good investment due to future growth.

Just for fun, let's just take a look at what BPS has done over time at WFC.  If we are going to pay close to 1.5x book and our returns will come from growth in BPS instead of a valuation adjustment, we have to see what BPS has done and think about what it might be able to do in the future.

             BPS        DPS
2001       $8.00    $0.50
2002       $8.98    $0.55
2003     $10.15    $0.75
2004     $11.17    $0.93
2005     $12.12    $1.00
2006     $13.58    $1.08
2007     $14.45    $1.18
2008     $16.15    $1.30
2009     $20.03    $0.49
2010     $22.49    $0.20
2011     $24.64    $0.48
2012     $27.64    $0.88

So looking at it this way, it's pretty incredible.  Look at how much BPS has grown over time, and through the crisis too.

Here are the growth rates of BPS over five and ten year periods:

                       BPS growth per year
Five years          +13.9%
Ten years           +11.9%

But BPS growth excludes dividends, so let's add that back and see what BPS growth + dividends would have been:

                       BPS growth w/dividends
Five years       +18.2%
Ten years        +17.6%

That's pretty stunning.  This kind of record shows that BPS/share for WFC is a no-brainer long.  This BPS growth did get a one time bump up from the Wachovia merger, but it's still pretty impressive.

1.5x book value implies a 12%-ish sort of return.  Of course, with 1.5x book as a terminal value, then the return can be 18% over time if they do just as well in the future as they have done in the recent past.  You can say that the last five - ten years was an outlier bad period for financials (but others would argue that the 2005-2007 was outlier good years so it balances out).

In any case, either way, 15% ROE seems achievable and the same would apply here.  You can say 15% ROE = 10% return at 1.5x book, or if you see 1.5x as fair value going forward with no change in terminal value for the foreseeable future, you can expect a 15% return over time even at 1.5x book.

I tend to see things the first way; 15% ROE at 1.5x book = 10% expected return.  This may or may not make sense according to what you think.  But that's just the way I look at things and I think it's the conservative way to look at it.

Back to Buffett
So let's get back to Buffett.  He has been buying WFC even at non-distressed prices.  Why?  I remember when someone asked Buffett about banks and book value and Buffett said that book value is not important.  He does advocate ROE as an important measure of a business, but oddly enough, when discussing WFC during the crisis, he said it's not important.  At the time, he said the cost of capital was the most important thing; the one with the lowest cost will win.

(I think he does look at BPS and it is important to him, but maybe other factors are more important depending on the situation).

The other piece of the puzzle is Buffett's goal of earning a pretax 10% return.  This is what Buffett has been quoted as saying.  At last year's annual meeting I think he mentioned that he likes to pay 9-10x pretax earnings for a good business.

I think a while ago, Munger also mentioned using WFC as a benchmark to evaluate potential investments; if it's not better than WFC, why bother buying something else?   I may be wrong, but I do think that within the context of that discussion he mentioned that WFC can earn 10% pretax return on the then current price.

So that also confirms that this is the valuation benchmark at Berkshire.

Now you see where this is going.  For financials, the Street often uses 10% as the discount rate; if a financial company can only earn 5% ROE, then it's only worth 50% of book.  If it can earn 20% ROE (consistently), then it's worth 2x book etc...

Using Buffett's valuation measure, you will get a different result.

So let's go back to WFC with this new valuation tool (well, it's not new but...).

WFC at 10x Pretax Earnings
In the year just ended, WFC had pretax earnings of $27.1 billion (I added the $9.1 billion in income tax expense to the $18 billion net to common; the pretax income on the income statement includes minority interest and dividends payable to preferreds so $27.1 billion gives us pretax income to common shareholders).

Using Buffett's measure, WFC is worth $271 billion.  With 5.266 billion shares outstanding,  that comes to $51.46/share.

WFC is trading at $35/share now so that's a 70 cent dollar right there.  That's 50% upside, not in two years, but NOW! 

And keep in mind, this is not intrinsic value or fair value or anything like that; it's a price that Buffett would happily pay for the shares.  He says he wants to pay 10x pretax earnings, right?  He needs to earn a 10% pretax return, right?  Well, $51.46/share gives you that.

But, but, but...
This price would come to close to 2x book.  What kind of nonsense is that?  How can a financial stock trade at 2x book in this post-crisis, new, new normal world?  I know.  It sounds ridiculous.  If I said this out loud in a bar downtown near the New York Stock Exchange, I would get laughed right out of the room.

But I'm just putting things together.  There is nothing new here.  I am not making big projections, assuming anything incredible or anything.  I just took some facts that are out there and just slapped them together and that's what you get.

Also, I know most people still fear banks and think another crisis is around the corner.  Well, if you are a WFC shareholder and see what it did during the last crisis, then you should be praying for another crisis!

Rich Get Richer During Bad Times (or Big Get Bigger)
I will put another piece of the puzzle here.  At one of the recent annual meetings, Munger talked about how Rockefeller, Carnegie and others got rich.  They got rich during the bad times.  When bad times hit, these guys grew by buying up the distressed competitors.  This is how it's always been, so it's silly to worry about bad times.  Munger said that if you don't get it, you are an idiot (maybe he had a more elegant way of saying it, but I do remember he said it strongly).

I think this was in a context of answering a question about some fear about the future (of the macro outlook, stock market etc...).

And if you look at the above BPS growth of WFC, you can see how exactly right Munger is.  WFC shareholders should wish for a financial crisis every year!  (WFC grew BPS including dividends at +18%/year in the last five years; it grew BPS + dividends 27% in 2009.  How many hedge funds (who are supposed to make money in volatile markets) made a 27% or better return in 2009? And of those that did, how many have not given it back?).

Buying distressed asset funds / private equity funds / hedge funds to take advantage of volatility and bad times may not be a bad idea, but here is a company that is is doing it, right in front of our eyes.  They do very well in good times and even better in bad times.  Why do people bother looking for someone to hedge their 'deltas', give them non-correlated, leveraged alphas and things like that?  Sometimes (or most of the time), the medicine kills the patient; this need to reduce or eliminate perceived risk ends up killing them.   And sometimes the answers are just so simple.

Anyway, others will point to the one time-ness of the accelerated BPS gains by WFC because of the crisis, but you can't have it both ways.  You can't argue that WFC is no good because another crisis is around the corner, and then worry that the BPS gains in the recent past is one-off so not indicative.

Conclusion
So there you have it.  The greatest investor of all time will be buying WFC all the way up to $50/share (and this will keep going up over time).  And for those worried about another financial crisis around the corner, you want to own a company that will benefit from it.  If you buy WFC and study it's history, you will just start praying for another crisis instead of worrying about it.

What's not to like?

I get it.

(No, I do not own WFC at this time.  I have owned it in the past and may in the future.  By using the above measure, maybe JPM / BAC / GS are even cheaper than I think they are.)