There are some big value investment entities that have allocated a substantial percentage of their investable assets to investment in Wells Fargo (WFC) stock. Most notably, Warren Buffett has allocated 8.89% of Berkshire Hathaway’s stock investment portfolio to the mega-sized California bank. Elsewhere, New England Asset Management has allocated 21.16% of its portfolio to Wells Fargo, and other investment houses have done the following: Edgepoint Investment Group (8.26%), Theleme Partners (36.70%), Rothschild Wealth Management UK (10.53%), Magnolia Group (37.88%), Joseph Weiss LLC (23.67%), American Assets (23.14%), PM Capital (8.92%), DPM Capital (11.12%), Harbor Island Capital (11.31%), FSI Group (11.10%), and so on. In addition, Seth Klarman’s Baupost Group has devoted 6% of its assets to Wells Fargo and Charlie Munger’s Daily Journal has a huge chunk of Wells Fargo that was purchased at $8 per share (the absolute low) during the financial crisis.
Outside of Berkshire Hathaway, Alphabet, Apple, and Amazon, it is rare to see huge funds and other investment entities devoting such a large percentage of their portfolio to a bank. What is it about Wells Fargo that seems to draw in these value investors to not only buy the stock, but to buy it in such disproportionate quantities?
The answer is that the mega-cap is one of the largest, most-overcapitalized, secure financial investments that exists in the world. Currently, 99.4% of its loans are “performing” (defined as a loan in which the borrower is either current on obligations or up to 90 days overdue). It has had to charge off less than 1% of its total loans for the entire past decade, mostly because it has over half-a-trillion dollars tied up in mortgages in the middle-class and upper-class areas of fast-growing states.
It has a common equity ratio of 12%. Basically, this means that Wells Fargo’s leverage (loans compared to deposits) is less than one-tenth. In other words, if the bank takes in $1,000,000 in deposits, it turns around and makes $10,000,000 in loans to customers. I do run the risk of oversimplification when I say that because intangible assets are also included in the calculation of a bank’s common equity ratio. Any way, Prior to the Basel regulations in connection with the financial crisis, a ratio above 10% was considered the gold standard for bank safety. The problem was that banks like Washington Mutual were leveraged over 30 to 1 while also lending to much lower-quality borrowers.
What I suspect has always caught Warren Buffett’s (and value investors with similar methodologies) attention is that the company traditionally grows its loan portfolio by about 7% per year without lowering its loan quality. That is because it has established relationship and is often the preferred lender to many other large-cap American businesses. Who do you think gives billions and billions of dollars to Chevron, Apple, and Microsoft when they need to take on debt to repurchase shares in the United States because their profits are sourced internationally and they don’t want to pay the repatriation tax? That’s all Wells Fargo money.
If this account scandal of the past several years did not occur, Wells Fargo would be trading at a $80 or $90 valuation range. Take a look at what JP Morgan stock has been doing the five years and Wells Fargo would be in the same position if it did not open up fake accounts and defraud customers in certain areas along the way.
Of course, we have to live in a world and invest in a time and place where that *did* happen. This is the part where you have to stop and remind yourself that successful investing is not about seeing what you want to happen, but making probabilistic wagers about things that you think *will* happen. I have many conservative friends who thought Starbucks or Target would endure various boycotts during the past couple years, but that was mostly because they wanted to see it fail due for political reasons. Well, the analytical approach is look at the demographics of Starbucks and Target customers and see that almost 80% of Starbucks and Target customers lean to the left politically, so things that might be offensive to independents or conservatives are not going to deter them.
Similarly, there are a lot of people out there with a Kantian sense of fairness that think, “Wait a minute, if a bank is going to defraud people, why should it prevail over the long run?” The answer is that large businesses need to borrow billions of dollars, and million-dollar parcels of real estate need to be mortgaged. There are only a couple dozen lenders in the entire world up to that task, and on the West Coast particularly, a Wells Fargo banker could very well be the only person that can get you money fast, at a lower interest rate, with less red tape, or some type of combination thereof.
Walt Disney. Oracle. Intel. McKesson. HP. Petco. Facebook. Tesla. Paypal. LA Fitness. Edwards Lifesciences. Electronic Arts. Heck, even the San Diego School District. What do all of these seemingly disparate entities have in common? At some point in the past five years, each of them has borrowed $1 billion (or more) from Wells Fargo. And that relationship is entrenched. If you need to borrow a billion dollars from someone, where do you look? To the guy who gave you a billion dollars the last time.
Also, there are benefits that come along with its loan strategy. Wells Fargo bets heavily on real estate in California, Texas, and Florida in that it has dedicated more mortgage dollars to those states than any other lender over the past decade. In aggregate, the value of real estate in those three states has increased at an annual rate of 7.1% annually from 2010-2020 while the United States as a whole has experienced 3.7% annual appreciation in its real estate. By focusing in markets where appreciation of real property comes quickly, it naturally has more “collectible” loans because they are secured by assets that increase faster than the assets of other banks. Wells Fargo effectively arbitrages the difference in real estate prosperity between U.S. states based upon the markets where it devotes its biggest secured lending.
Right now, Wells Fargo is yielding over 4% (based upon a stock price of $49 per share). As part of the Fed’s limitations on its capital return policies, namely dividends and share repurchases, Wells Fargo is storing capital at a higher rate that will be unleashed in the future. It is positioning itself for long-term earnings per share growth of 7.5% with dividend hikes accordingly. For a yield that starts at slightly above 4%, high single-digit dividend growth and earnings per share growth over the long-term is likely to be a recipe for 10-12% annual returns. Given that Wells Fargo is already a trillion-dollar bank in terms of assets, that would be a colossal achievement. I expect that a day will come when all the heavy betters on Wells Fargo stock will have a period of sharp outperformance when the investor community wakes up and chooses to recognize that Wells Fargo and JP Morgan are coastal twins and deserve the same valuation.