Buffett always highlights that the banking business is not one of his favorites because mistakes in a small portion of assets can destroy large portions and mistakes are considered a rule in many important banks. For this great investor, executives tend to imitate their peers behavior, no matter how foolishly they may act.
Buffett and his team have a particular thinking about banks: Rather than investing in poorly-managed banks at a cheap price they prefer to invest in well-managed banks at fair prices.
In the case of Wells Fargo, Buffett thought he obtained the best managers: Carl Reichardt and Paul Hazen. Why did he think so? First, because the pair was stronger than the sum of the parts. Second, managerial teams paid people well. Third, both could attack costs when profits are at record level and they feel under pressure.
The Wells Fargo purchase was driven by a chaotic market in bank stocks. Every month, loan decisions made by well-regarded banks were disclosed to the public and huge losses were unveiled too. This made investors conclude that these figures could not be trusted. This fail of trust by investors enabled Buffett to buy his position at Wells Fargo at $290 million, less than five times after-tax earnings and less than three times pre-tax earnings.
Why did Buffett turn to Wells Fargo? At the time of the buy, the company had $56 million in assets and was earning more than 20% on equity and 1.25% on assets. The purchase of one-tenth of Wells Fargo could be compared to the purchase of 100% of a $5 billion bank with the same financial characteristics. The difference is that Buffett and his team would have paid much more than what they invested in Wells Fargo and would not have found such good managers as those that were running Wells Fargo.
Of course, Buffett knew that buying a bank was risky. To start with, the bank could face a major earthquake; secondly, it could suffer a business contraction or financial panic to such extent that it would endanger the whole institution; and finally, the West Coast real estate values could tumble because of overbuilding.
Fortunately, Wells Fargo was in such position that the probability of the two first risks was low and the meaningful drop in real estate values was unlikely to cause major problems. Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Surprisingly, Buffett welcomed the decline because his company could pick up more shares.
This philosophy that Buffett adopted when he bought Wells Fargo should be largely followed by others throughout their lifetime, instead of becoming euphoric when prices rise in stocks and unhappy when they fall.
It is believed that pessimism causes low prices. Optimism is the real enemy to a rational buyer.
However, this does not mean that the purchase of a business or stock is intelligent just because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy.
What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do."