Buffett wrote: “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 when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the foolish behavior of their peers. 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.”
With Wells Fargo, Buffett was thinking about “the best managers in the business, Carl Reichardt and Paul Hazen.” Both managed costs wisely when profits were at record levels as well as when they are under pressure. Both managers did what they understood and did not let their egos determine what they attempt.
Buffett’s Berkshire purchases of Wells Fargo in 1990 were helped by investors’ flight away from bank stocks. Berkshire purchased a 10% interest in Wells Fargo for $290 million, which was less than five times after-tax earnings. Interestingly, Buffett did a similar move to buy more Wells Fargo stock in 2010 for similar bargain reasons.
Wells Fargo is big, and it has been earning higher-than-average returns on equity and returns on assets. The purchase of one-tenth of the bank has been described as roughly equivalent to Berkshire buying 100% of a $5 billion bank with identical financial characteristics.
Buffett described these risks. California banks face the specific risk of a major earthquake that could destroy banks. Another risk is a systemic risk. This almost came true during the great recession of 2008 and 2009. Buffett described this as: “the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run.”
In the recent financial crisis, WFC and other major banks were forced by the U.S. government to undergo stress tests and take infusions of cash in an effort to moderate the great credit crisis. Charlie Munger said Wells Fargo and U.S. Bancorp avoided many of the banking mistakes that led to the worldwide credit crisis and recession.
Buffett wrote that a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. In late 1980s, the market's major fear was that West Coast real estate values would tumble because of overbuilding. Because WFC was and is a leading real estate lender, Wells Fargo was thought to be vulnerable. Fears of a California real estate disaster caused the price of Wells Fargo stock to fall almost 50% in 1990. He welcomed the decline because it allowed him to buy more shares at the new, panic prices.
Wells Fargo & Company (NYSE:WFC), is the fourth-largest bank holding company in the U.S. It is best classified as a diversified financial services company with over 80 distinct businesses. WFC offers a full range of financial products and services. It targets all types of clients in all 50 states and the District of Columbia.
In 2010, Wells Fargo earned a total of $85 billion in total revenues and a net income of $12.4 billion. After acquiring Wachovia, it became the nation's largest mortgage lender and the second-largest diversified financial service deposits firm in the U.S.
As part of the TARP deal to raise enough cash for the Wachovia rescue acquisition, Wells Fargos sold $12.6 billion in common stock and $25 billion in preferred stock to the U.S. government through the $700 billion Troubled Assets Relief Program (TARP).
Like all major banks, Wells Fargo has been negatively impacted by the credit crunch and the economic decline. However, Wells Fargo was not forced to write down large losses on its assets.
Wells Fargo raised $12.25 billion in a stock sale to help repay the $25 billion in Troubled Assets Relief Program (TARP) crisis money. Although this diluted Wells Fargo's shares by approximately ten percent, it allows the bank to avoid paying an annual dividend to the government of $1.25 billion. This also frees WFC from added government oversight.
Wells Fargo separates its businesses into three main segments for revenue reporting purposes: 1.) Community Banking, 2.) Wholesale Banking, and 3.) Wealth, Brokerage, and Retirement. Wells Fargo's Community Banking business serves small business clients as well as retail customers. It also provides a wide range of services in investment, insurance and trust services to high-net-worth individuals.
WFC offers its products through a variety of channels, including the company's regional banking branches, over 6,700 ATMs, website and telephone banking service. Wells Fargo's large credit card business, now part of its Community Banking, has issued over 7.7 million credit cards and over 20 million debit cards. This makes it the second-largest debit card issuer in the U.S. As a credit card issuer, it charges interchange fees, interest on outstanding customer balances, and fees such as late or missing payment fees, exceeding credit limit fees, and monthly or annual membership fees.
Wells Fargo's Wholesale Banking Group serves business clients with annual sales exceeding $10 million. Wholesale Banking is responsible for a line of corporate, commercial, and real estate banking products and services. This includes institutional investments, employee benefit trusts, investment banking, construction loans, and insurance.
After the Wachovia Bank acquisition, WFC was also able to expand its product services to include investment banking, equity trading, fixed-income sales and trading, and equity and fixed-income research.
Wells Fargo has also teamed up with Visa (V) to pilot test a mobile payments system. Competition for mobile payments dominance between credit card companies and telecom companies may have huge implications for future earnings as this market develops.
Wells Fargo's mortgage lending business was hit by slow growth and falling residential real estate prices. The number of total housing starts fell about 63% since peak levels during the end of the housing boom. However, Wells Fargo dealt with mortgage setbacks relatively well due to its wide diversification in product offerings.
The housing slowdown is often attributed to the collapse of the subprime lending market. Wells Fargo fared better than most competitors in the mortgage business because its mortgages are predominately prime and near-prime. As a result, Wells Fargo did not experience the high rates of default seen in the subprime market. Wells Fargo has avoided much of these losses by deciding not to extend or purchase option adjustable rate mortgages (option ARMs). However, Wachovia Bank, acquired by Wells Fargo at a bargain, took part in Option ARMs and subprime lending.
With 6,795 branches and $760 billion in total domestic deposits, Wells Fargo focuses its business operations on the domestic U.S. market. Its major competitors include Bank of America (BAC), JP Morgan Chase (JPM) and Citigroup (C).
Wells Fargo is strongly focused on the U.S. market. Wells Fargo has less international exposure than its top competitors. While this does allow Wells Fargo to focus its resources on gaining greater market share within the U.S., it is more vulnerable to U.S. economic cycles. WFC does not have foreign markets to buffer domestic performance.
According to John Stumpf, chairman and CEO, Wells Fargo’s biggest competitive advantage is its employees. The company looks for talent in different cultures and backgrounds and provides them with the necessary training. Wells Fargo’s culture recognizes and rewards an outstanding performance. As a result, 27 years is an average tenure for Wells Fargo’s wholesale leadership members.
Wells Fargo also focuses on customer retention. It has over ten-year-long relationships with 40% of its customers. Such high retention rates enable cross-selling of products. In 2009, the average number of products per wholesale relationship were 6.47, a steady increase from 4.84 in 2003.
Recently, WFC’s five-year net profit margin (five-year average) is approximately 15.4%, while the industry net profit margin (five-year average) is 16.5%, and the S&P net profit margin (five-year average) is 11.5%.
Wells Fargo also uses its size and financial reserves as a competitive advantage. The current economical crisis has shown that no bank is too big to fail. Therefore, Wells Fargo will have to stay with its core values by focusing on its current customers and refraining from assuming too much risk in the mortgage market.
author of "The Four Filters Invention of Warren Buffett & Charlie Munger" and "Moats: The Competitive Advantages of Buffett & Munger Businesses"