After Iraq attacked Kuwait in August 1990, the United States entered a full-blown recession. On the one hand, stock prices—including Berkshire’s—collapsed, down more than 25 percent from their high a year before. On the other hand, valuations finally came back down to earth after the great bull market run of the 1980s. Also in 1990, California real estate was taking a turn for the worse, and all indications seemed to point to a severe and lengthy period of misery for banks that wrote mortgages. This was especially troubling for Wells Fargo because it was the bank that had written more mortgages in California than any other. However, Wells Fargo was also one of the most profitable banks in the nation, with an especially strongly entrenched franchise in California. It was chaired by Carl Reichardt, who had a reputation as a true efficiency-minded executive.
In its 1989 annual report,1 the Wells Fargo management team—led by President Paul Hazen and Chairman and CEO Carl Reichardt—gave a clear description of their main business divisions, starting on page one. (Note that the 1989 annual report, dated March 6, 1990, would have been the latest full annual report available to a potential investor in early/mid-1990.) Wells Fargo was organized into four divisions. Although financial figures are not broken down in the annual report along these business divisions, the management discussion gave enough information to understand what—and more important, how—the businesses were doing.
Figure 16.1.
The first division was the retail and branch banking division. This was described as the largest division, generating the bulk of the bank’s $36.4 billion in deposits and also approximately 40 percent of its outstanding loan portfolio of $41.7 billion. The loans made in this division came in the form of consumer, small business, and home mortgage loans. In 1989, the company focused on building a core branch network in California and pursued a strategy of what it called “strengthening customer ties.” This meant acquiring branch networks, including Bank of Paradise in Butte County, Valley National Bank of Glendale, the American National Bank of Bakersfield, and the Torrey Pines Group of San Diego County. It also meant divesting many of Wells Fargo’s international offices and forming partnerships abroad instead.
The second division—commercial and corporate banking—provided commercial enterprises with loans. This division also provided fee-based services to commercial customers, including cash management and transaction processing. During the year, the focus in this division was also on building additional density in California. This included traditional commercial businesses as well as a significant portion of agricultural businesses.
The third division—real estate lending—provided real estate loans, including both mortgages and construction loans. Together with the loans provided by the commercial and corporate division, these loans accounted for the remaining 60 percent of the bank’s outstanding loan portfolio totaling $41.7 billion. This division was also concerned with community development and had some marquee projects funded with Wells Fargo financing, including some of the largest social housing projects at the time in Los Angeles.
The last business was the investment management business. This included an index fund manager called Wells Fargo Investment Advisors and a private banking division that managed the wealth of private individuals and trusts. The former had assets under management of $80 billion and the latter assets under management of $34 billion. Some of the new product offerings being introduced in this division included Product Maximizer, which offered investors with accounts over $250,000 full securities brokerage and advisory services.
All in all, what seemed clear from the discussion in the annual report is that the four divisions of Wells Fargo acted as one integrated overall business; this one entity was supported by retail branches with diverse offerings for individuals as well as businesses. As such, the ensuing discussion about Wells Fargo’s financial performance also focused on the overall business.
According to those financials, in 1989 net income was $601.1 million and $11.02 on a per share basis. Compared to the previous year, net income increased by 17 percent, and EPS increased by 20 percent. Return on assets (ROA) was 1.26 percent, and return on equity (ROE) was 24.5 percent. These were improvements compared to a ROA of 1.14 percent and 24.0 percent in 1988. In absolute terms, these returns were significantly above the industry average for banks. Just to give perspective: A 24 percent return on equity means that for $100 of a bank’s money, the bank is getting a return of $24 in that year. This is a very healthy return by any standard.
Management next details how the $601.1 million net income was generated by breaking down net interest income and noninterest income. The single largest contributor to interest income was the loans made by the bank. On the interest cost side, the largest single cost related to funding source were different forms of savings deposits. Major generators of noninterest income included diverse transaction fees and commissions, services charges on deposit accounts, and income from trust and investment management. Based on these figures, Wells Fargo would have seemed to a potential investor to be very much a deposit bank whose bulk of business was serving depositors and making loans. There were no significant businesses involving derivatives or alternative business models.2
The management next discusses the balance sheet figures, going into detail on those assets and loans that are at the core of the bank’s income generation. On the asset side, loans were the focus and made up $41 billion of the $48.7 billion in total assets at year-end. The corresponding average balances during the year were $39.4 billion in loans and $47.8 billion in total assets. By category, management discusses positive developments in several of the loan categories with some comments. I have summarized this information in table 16.1.
Table 16.1.
Loan development by category
| Category |
Avg. balance |
YOY change |
Comments |
| Commercial loans |
$14.2 billion |
+14% |
Growth in corporate, midmarket loans |
| Real estate construction |
$4.4 billion |
−4% |
|
| Real estate mortgage |
$11.7 billion |
+19% |
Growth in 1–4 family first mortgages |
| Consumer |
$7.6 billion |
+6% |
|
| Other |
$1.5 billion |
−48% |
Significant decrease in foreign loans |
| Total |
$39.4 billion |
+7% |
|
As one can see, the overall asset growth stems primarily from increases in corporate and midmarket loans and growth in one to four family real estate mortgages. Most of these loans were in the state of California because Wells Fargo had a primary interest in California.
Here, we should take a brief look at the investing environment in the banking industry at the time because a potential investor would consider the context quite important. In 1989, the banking industry of the United States was in a period of significant consolidation and “cleansing.” In the wake of a general economic slowdown predicated by the high interest rates (tightening of credit markets) of the 1980s, along with a real estate recession (1986–1991), many of the savings and loan associations as well as the weaker banks were having serious issues. Those institutions that had not been prudent in their lending practices were regularly making negative news, and many, in fact, went bankrupt. Although this period was also marked by stronger banks that were able to consolidate the assets of these weaker players—often at favorable valuations—it was difficult to tell the good players from the bad. In total, between 1980 and 1990, the number of S&Ls was said to have been reduced by roughly 50 percent and the number of commercial banks by 20 percent.
As a result of this turmoil, banking assets in general were heavily sold down. There was a fear that Wells Fargo would face a fate to that of some of the lesser banks. Taking a look at the stock price of Wells Fargo in 1990, for the period that a possible investor would have considered the shares, one would have seen wild swings in prices with a steep drop in Q3 and Q4 1990 (this, as it happens, is when Warren Buffett purchased his shares).3 These fears were not completely unfounded. Wells Fargo, as mentioned previously, was significantly exposed to real estate loans both in construction and mortgages. The bulk of these loans were made in California, which after years of property price increases, was certainly at risk of suffering a real estate price correction.
However, the financial numbers presented by Wells Fargo in the 1989 annual report showed positive financial developments. A potential investor would also have considered the risk metrics reported by Wells Fargo. They came in the form of capital ratios and loss reserve developments of loan losses. In terms of capital ratios, Wells Fargo reported a tier 1 risk-based capital ratio of 4.95 percent at year-end 1989. Tier 1 capital is based on common stockholders’ equity and qualifying preferred stock. Compared to the ratio at year-end 1988 of 4.57 percent, this was an improvement. It was also significantly above the level stipulated then by the Federal Reserve Board (FRB), which was four percent.4 When looking at overdue and bad loans, one sees in table 16.2 that the total amount of loans 90 days or more past due was $126.8 million, representing 0.32 percent of loans in 1989.
Table 16.2.
Loans 90 days or more past due and still accruing
| Year ended Dec. 31 |
| (In millions) |
| |
1989 |
1988 |
1987 |
1986 |
1985 |
| Commercial, financial, and agricultural |
$46.4 |
$34.6 |
$51.5 |
$71.1 |
$46.1 |
| Real estate construction |
2.3 |
30.7 |
6.1 |
11.2 |
14.3 |
| Real estate mortgage |
28.6 |
26.9 |
41.3 |
65.4 |
42.0 |
| Consumer |
47.8 |
35.9 |
35.3 |
62.9 |
43.5 |
| Lease financing |
1.7 |
2.1 |
1.3 |
1.7 |
0.2 |
| Foreign |
— |
— |
— |
3.7 |
1.5 |
| Total |
$126.8 |
$130.2 |
$135.5 |
$216.0 |
$147.6 |
Source: Based on Wells Fargo, 1989 Annual Report, p. 15, table 12.
This was less than the comparable $130.2 million figure in 1988, both in dollar terms and as a percentage of total loans. All this would have seemed fairly reassuring. The same would have been the conclusion looking at management’s discussion of allowances for loan losses. At year-end 1989, the allowance for loan losses totaled 1.77 percent of total loans, lower than the two percent figure in 1988. This was based on the best judgment of the management. In the end, the fears regarding the collapse of Wells Fargo from its exposure to real estate loans were, from what I could tell, not reflected in the financials reported by Wells Fargo in early 1990. This is not to say that Wells Fargo would never have issues with its exposure in California real estate; but if one believed in the management team and the financials of the company, one would not have seen evidence of a deterioration of the business at this time from the reported numbers. Wells Fargo seemed to be a well-run bank with above-average metrics both in terms of income and its risk profile. Moreover, it seemed to be improving those already impressive metrics year after year for the last several years.
I turn now to valuation. Given the knowledge that Buffett paid an average of $57.88 per share for his purchase in Wells Fargo in 1990,5 one can draw two conclusions. First, Buffett had purchased the bulk of his stake in Wells Fargo in Q3 and Q4 1990, as prices during the year only dipped below $60 per share during those quarters. Second, the price ranged between $42.75 and $80.13; if one assumes that the price a potential investor had at the time was $58.00 per share (roughly the average price for Buffett) the valuation would have looked as described in the following paragraphs.
Based on the consolidated financial statements presented in the 1989 annual report, which is included at the end of this chapter, the market capitalization of Wells Fargo would have been $3.2 billion.
Table 16.3.
Calculation of market capitalization
| Share price |
$58.00 |
| Number of shares outstanding* |
54.98m |
| Market capitalization |
$3,189m |
*Shares outstanding as reported at year-end 1987 included 51.10 million common shares and 4.5 million preferred shares. I have assumed a $50 per share price of the preferred shares as they were redeemable by the company at a price of approximately $50 per share and had a yield at the time slightly below that of the 10-year bond rate. The resulting valuation is equivalent to 3.88 million shares of common stock. I have not considered stock options because the company quotes them to be “not material.”
Because Wells Fargo is a bank, I would have focused on the PER and P/B metrics in making the valuation of the company. I would take enterprise value as less relevant given the highly leveraged (in terms of financial assets and debt) balance sheet inherent to a bank.
Table 16.4.
PER multiples
| PER |
1988 |
1989 |
| Share price |
$58.00 |
$58.00 |
| EPS as reported |
$9.20 |
$11.02 |
| PER |
6.3× |
5.3× |
Based on the historical 1989 net earnings, Wells Fargo would have been trading at approximately five times net earnings. This is very cheap if one believes in the credibility of the balance sheet presented by the management, that is, if there were not very significant write-offs to be taken on the assets from loans gone bad. If an investor had purchased Wells Fargo at its 1990 low of $42.75, the PER ratio would have been at an even more incredible 3.9 times last year’s net earnings. Finally, although as a value investor I would not have cared about the dividend yield itself, the fact that the management intended to pay almost $4 per share in dividends in 1990 would have seemed a very confident signal about the prospects of the company. In addition, Wells Fargo was also buying its own shares at this time.
Moving on to the P/B valuation, one can see that the shareholders’ equity totaled $2,861 million at the end of 1989. As the market capitalization was $3,189 million, the P/B ratio at the end of 1989 would have been 1.1×. This meant that the business was valued at slightly more than its book value based on the $58 per share value. Although this is not necessarily bargain-basement cheap for a bank, it is certainly very cheap for a bank that makes a ROE of more than 20 percent. A potential investor might have thought through it like this: Given a bank that earns a ROE equal to its cost of capital, the fair net worth should be roughly equal to the book value; but if a bank or business earned, say, a return of 16 percent when the average cost of capital is eight percent, then it should be roughly worth twice as much as book value. A business like Wells Fargo, assuming that its ROE of 24 percent was sustainable, clearly should be worth even more than that. Hence, a valuation of 1.1 times book value is very cheap for Wells Fargo, given that it has a proven track record of earning a return greater than 20 percent.
To give a calibration on the actual valuation of Wells Fargo, consider that in order for Wells Fargo to have a 10 times PER or two times P/B, which is more fair (but still conservative) at a share price of $58 per share, its earnings would need to be cut roughly in half from $601 million to $300 million. Given that bad loans outstanding were $126 million, this would mean that bad loans would have to more than triple to impair the earnings of 1989 by a sufficient amount to justify the share price. Moreover, this impairment would have to be ongoing indefinitely into the future—a scenario that seems fairly unlikely. Thus, I would have considered there to be a meaningful margin of safety.
A last comment on the core business quality before concluding: It should be mentioned that Wells Fargo seemed to have several specific advantages and strengths in addition to what is presented in the numbers. First, its management team was not only very competent, but also had been with the company for many years. They also had been around during the real estate recessions of 1973 to 1975 and 1981 to 1982, giving confidence that their loan practices had been conservative. Management also speaks intelligently and sensibly in their annual report, which I would have found indicative of a competent management team. Second, although Wells Fargo ranked third of all banks at the time in total assets in California, it was the largest middle market lender, commercial real estate lender, and second in terms of retail deposits. In effect, it had a competitive and well-known area of expertise, and management planned on building on those strengths.
In sum, to a potential investor in early/mid-1990 Wells Fargo seemed to be a very well-run bank with clearly better-than-industry-average financial metrics that were improving year-over-year. Its strategy focused on better serving its California customers. While this meant a sensible focus and improving operations, it also meant exposure to California real estate loans that would have concerned some investors. However, based on its capital ratios, loan loss metrics, and commentary of loan loss allowances, there were few facts that should have deeply concerned investors already at that time. The valuation of Wells Fargo’s stock at approximately five times PER and 1.1 times P/B seems like a deep discount considering the earnings power and risks of the business seen at that time.
Based on this knowledge, it seems that Buffett’s investment in Wells Fargo was a case where he purchased a good business that had historically been superior to peers, run by a good management team he trusted, at an outstanding valuation. This case differs from his investments in Coca-Cola and American Express because the inherent quality of the business and its growth economics were perhaps associated with much more risk and less favorable underpinnings—though in the case of Wells Fargo, he also did not pay for any growth. It also seems that Buffett trusted the positive key financial metrics provided by the management in the annual reports and did not rely on the negative circumstantial evidence of other banks’ failures when assessing the future of Wells Fargo. It is likely that Buffett’s judgment about Wells Fargo’s risks included more primary research on loan losses, but his conclusion was certainly consistent with the positive data and outlook presented by the Wells Fargo management at the time.
Following Buffett’s purchase in 1990, and after reporting a good set of numbers for fiscal year 1990, Wells Fargo did go through increasing pressure on loan losses in 1991. Specifically, issues related to loans made in commercial real estate caused Wells Fargo to increase its loss allowance to $1.65 billion or 3.73 percent of total loans (about double the allowance in 1989). However, the 1991 annual report also showed that in terms of Wells Fargo’s stock price, it would trade between $48 and $97 in that year, significantly higher on average than the year before. The reality was that there were some risks that the market saw correctly, but that the margin of safety presented by the valuation in 1990 already was more than priced in any future negative news. In the slightly longer term, Wells Fargo recovered to become a very successful bank and continues to be one of Berkshire Hathaway’s largest positions with enormous unrealized gains today.
Income statement (1987–1989)
| Year ended Dec. 31 |
| ($ in millions except per share data) |
| |
1989 |
1988 |
1987 |
| Interest income |
|
|
|
| Loans |
4,582.5 |
4,889.5 |
3,602.5 |
| Interest-earning deposits |
3.7 |
10.2 |
99.4 |
| Investment securities |
281.0 |
268.7 |
250.8 |
| Trading account securities |
0.1 |
3.8 |
7.6 |
| Federal funds sold |
2.9 |
5.3 |
7.7 |
| Total interest income |
4,870.2 |
4,177.5 |
3,967.5 |
| Interest expense |
|
|
|
| Deposits |
1,810.1 |
1,560.3 |
1,463.5 |
| Short-term borrowings |
645.3 |
370.2 |
364.8 |
| Senior and subordinated debt |
256.2 |
274.9 |
337.6 |
| Total interest expense |
2,711.6 |
2,205.4 |
2,165.9 |
| Net interest income |
2,158.6 |
1,972.1 |
1,801.6 |
| Provision for loan losses |
362.0 |
300.0 |
892.0 |
| Net interest income after provision for loan losses |
1,796.6 |
1,672.1 |
909.6 |
| Noninterest income |
|
|
|
| Domestic fees and commissions |
283.7 |
278.2 |
270.8 |
| Services charges on deposit accounts |
246.7 |
219.6 |
180.6 |
| Trust and investment services income |
178.2 |
153.7 |
156.5 |
| Investment securities losses |
−2.7 |
−4.3 |
−12.9 |
| Other |
72.8 |
35.0 |
5.0 |
| Total noninterest income |
778.7 |
682.2 |
600.0 |
| Noninterest expense |
|
|
|
| Salaries |
631.3 |
619.8 |
599.3 |
| Employee benefits |
149.2 |
152.4 |
151.5 |
| Net occupancy |
178.5 |
166.8 |
178.7 |
| Equipment |
137.3 |
135.8 |
132.9 |
| Other |
478.2 |
444.3 |
458.1 |
| Total noninterest expense |
1,574.5 |
1,519.1 |
1,520.5 |
| Net noninterest income |
−795.8 |
−836.9 |
−920.5 |
| Income/loss before income tax expense/benefit |
1,000.8 |
835.2 |
−10.9 |
| Income tax expense/benefit |
399.7 |
322.7 |
−61.7 |
| Net income |
601.1 |
512.5 |
50.8 |
| Net income applicable to common stock |
573.6 |
486.7 |
28.0 |
| Per common share |
|
|
|
| Net income |
11.02 |
9.20 |
0.52 |
| Dividends declared |
3.30 |
2.45 |
1.67 |
| Average common shares outstanding |
52.1 |
52.9 |
53.8 |
Source: Wells Fargo, 1989 Annual Report, 22.
Balance sheet (1988–1989)
| Year ended Dec. 31 |
| ($ in millions) |
| |
1989 |
1988 |
| Assets |
|
|
| Cash and due from banks |
2,929.8 |
2,563.2 |
| Interest-earning deposits |
5.1 |
322.1 |
| Investment securities (market value $1,704.9 and $3,799.8) |
1,737.7 |
3,970.4 |
| Federal funds sold |
6.3 |
27.0 |
| Loans |
41,726.9 |
37,670.0 |
| Allowance for loan losses |
738.6 |
752.1 |
| Net loans |
40,988.3 |
36,917.9 |
| Premises and equipment, net |
679.6 |
688.0 |
| Due from customers and acceptances |
211.0 |
244.9 |
| Goodwill |
352.6 |
373.4 |
| Accrued interest receivable |
389.9 |
365.7 |
| Other assets |
1,436.3 |
1,143.9 |
| TOTAL ASSETS |
48,736.6 |
46,616.5 |
| Liabilities and stockholders’ equity |
|
|
| Deposits |
|
|
| Noninterest-bearing—domestic |
8,003.2 |
7,105.5 |
| Noninterest-bearing—foreign |
— |
7.0 |
| Interest-bearing—domestic |
28,153.7 |
26,580.3 |
| Interest-bearing—foreign |
273.4 |
1,376.0 |
| Total deposits |
36,430.3 |
35,068.8 |
| Short-term borrowings: |
|
|
| Federal funds borrowed and repurchase agreements |
2,706.7 |
2,207.2 |
| Commercial paper outstanding |
3,090.4 |
2,747.7 |
| Other |
44.3 |
47.4 |
| Total short-term borrowings |
5,841.4 |
5,002.3 |
| Acceptances outstanding |
211.0 |
244.9 |
| Accrued interest payable |
100.8 |
110.1 |
| Service debt |
695.2 |
923.0 |
| Other liabilities |
751.2 |
693.9 |
| Total |
44,029.9 |
42,043.0 |
| Subordinated debt |
1,845.8 |
1,994.1 |
| TOTAL LIABILITIES |
45,875.7 |
44,037.1 |
| Stockholders’ equity |
|
|
| Preferred stock |
405.0 |
405.0 |
| Common stock—$5 par value, authorized—150 million shares; issued and outstanding 51,074,971 shares and 52,546,310 shares |
255.4 |
262.7 |
| Additional paid in capital |
274.1 |
389.7 |
| Retained earnings |
1,930.7 |
1,528.2 |
| Cumulative foreign currency translation adjustments |
−4.3 |
−6.2 |
| Total stockholders’ equity |
2,860.9 |
2,579.4 |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY |
48,736.6 |
46,616.5 |
Source: Wells Fargo, 1989 Annual Report, 23.
