I love looking at cheap stocks. When it comes to banks, I've traditionally started by looking at big discounts to tangible book value. But I've spent a lot of time thinking about why Buffett keeps buying Wells Fargo (which is the subject of another post I have to organize at some point).
There are different reasons for this, which I'll discuss later, but for now, the basic question I've considered is why does Buffett get so enthusiastic about paying two to three times tangible book for banks? And it's not because of his size. He easily could have plowed much more capital into large banks like Bank of America (BAC), Citigroup (C) and many other large liquid banks when they sold for a significant discount to tangible book (I realize he made some investments in some of these "other banks," but they were dwarfed by the size of his WFC position). Of course, the simple answer is that he feels Wells is the better business, and of course that's true. But what specifically does he like?
See my last post for some more thoughts on WFC, and I'll have more to say later, including some comments on the 1991 to 1993 annual reports that Buffett, Berkowitz, Greenblatt and others were looking at in real time when they decided to make significant investments into Wells Fargo in the early 1990s.
But for now, one thing to keep in mind when using simple valuation metrics like P/B is another Buffett comment on banks:
"You don't make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on."
I think what Buffett implies here is not to get too caught up with discounts to tangible book values if you plan to be a long-term owner of the business. Of course, that's how Buffett thinks of himself: a long-term business owner. Many pay lip service to this, but few actually think this way. I'm not sure that everyone buying bank stocks at huge discounts to tangible book necessarily think this way. They most likely are thinking about flipping their discounted merchandise to someone else once that merchandise gets priced fairly.
For example, you can buy a bank at 0.7 times book, sell it at 1.0 times book for roughly a 50% gain — a very simple strategy, and one that I like to consider as well — and not that this is right or wrong strategically, but it's definitely not how Buffett thinks, and I don't think he thought this way in the '50s and '60s either. I'll discuss this when I review my Commonwealth Bank case study later.
Buying and selling discounted merchandise is a very acceptable idea, and it likely works over time with these banks. One of Irving Kahn's first jobs when he went to work for Ben Graham was to make a list of all the bank stocks trading below 0.7 P/B.
Buffett does things differently, which doesn't necessarily mean better, but it has also certainly worked. One thing he looks for are banks that consistently have the lowest costs, and he determines that their cost structure (low-cost deposit base) along with their scale and size are huge competitive advantages. He is willing to pay well over book, and in some cases two to three times tangible book for quality banks like Wells Fargo (NYSE:WFC), US Bank (NYSE:USB), M&T and others.
How Has This Worked Out over Time?Very well. We all know about Wells Fargo, but think about this: In the last three decades, Wells Fargo's stock price has averaged about 16% per year including dividends! Wow, the S&P made about 8.5% CAGR before dividends during that time. Including dividends, let's call it about 11% per year for the S&P.
M&T Bank, another Buffett holding and a very high quality bank, has actually been one of the greatest performing stocks over the past 30 years, going from $1 to $113, and including dividends has averaged about 18% compounded annually!
Note: I'm assuming about 2% annual dividends (which likely is on the conservative side) because I didn't go back and check dividend yields for each year since the 1980s, but we can summarize the specific numbers for these two banks (adjusted for splits, but without the benefit of dividends) as follows:
- Stock price 30 years ago (12/12/1983): $1.38
- Stock price currently: $43.62
- Compounded Annual Growth Rate: 12.2% (not including dividends)
- Stock price 30 years ago (12/12/1983): $1.54
- Stock price currently: $113.92
- Compounded Annual Growth Rate: 15.4% (not including dividends)
- Index Value on 12/12/1983: 166
- Index Value on 12/12/2013: 1775
- CAGR: 8.2% (not including dividends)
These are long-time Buffett holdings, so I included them here, but there are many others. I came across this post when doing some research: 5 Top Bank Stocks in Last 30 Years. It references the two I focused on above, along with a few others like US Bancorp, State Street and Northern Trust. USB is another long-time Buffett holding, and not surprisingly has an incredible long-term record of creating shareholder value with a CAGR of about 13% not including dividends over the past 30 years. State Street and Northern Trust also have performed very well, with their stocks averaging around 13% to 14% per year before factoring in the benefit of dividends.
Perpetually High P/B MultiplesThe other interesting thing is that none of these banks appear to be cheap if you look at the price to tangible book values. And it's not that they sell for premiums now but were cheap historically. I checked various time periods over the past 15 years (as far back as I could find just by quickly glancing through Value Line) and found that all of these bank stocks have historically traded well over tangible book (often between two and three times tangible book).
In other words, at numerous times in the past, you could have paid two to three times tangible book for these quality banks, and simply held them and continued to achieve excellent returns over time.
So the bottom line is why are these banks so good, and how have they maintained such a durable competitive advantage over the course of the last 30 years? The answer would have to be the subject of another post, and there are a few factors to consider. One of course is management. But I think Buffett would sum it up by saying that these banks have consistently been the "low-cost" providers, meaning that because they were able to gather deposits more cheaply than everyone else, they were able to create higher returns (higher spread between the yield on their assets and the costs of gathering deposits). To paraphrase him once again, in the business of banking (and this is generally true for most industries), the company with the lowest cost wins.
A low cost structure is a huge advantage, and a significant margin of safety for banks.
What's the Point?
The intent here is not to say that I think the banks mentioned above are necessarily great investments and you should just buy them and forget about them. The intent here is to engage in some second-level type thinking to try and lay some initial groundwork for why Buffett is willing to pay much more than tangible book for a bank.
It's also interesting to compare the strategy of buying a cheap stock and waiting for multiple expansion (i.e. buying a bank at 0.7 times book when it's worth 1.0 times book and waiting for the market to assign the correct multiple) vs. the strategy of buying the best businesses that (thanks to their durable advantages) will continue to create above average returns on equity over time which translate into passive above average long-term investment results without the need for multiple expansion (i.e. you could have paid 2x book for WFC 20 years ago and it would have worked out very well, even though WFC only trades at about 1.5x book now).
Some view the former as more of a trading approach, and the latter as more of a long-term investment approach. I don't differentiate between the two. To me, a business owner can buy and sell businesses over time opportunistically, or he can hold the same business for years, or some combination of both.
So it's just two different concepts. They can be used separately or integrated together. I'm not suggesting one over the other. Graham and Schloss loved cheap stocks and did well buying, holding and selling them. Buffett and Munger like permanent compounders. As I've said many times, I've learned a lot by studying and integrating facets of their approaches.
One last comment on Buffett: We can look at what Buffett's doing now, and learn. Of course, the more relevant question might be "What would Buffett do now if he was starting from scratch with a small amount of capital?". He surely would be buying different stocks than he's buying now. He might still own some large caps, but he'd own many other smaller stocks. But I think he'd still be looking for quality stocks — he would just be looking for greater discounts to intrinsic value because he'd have more opportunity.
I think he'd still likely be looking at low-cost providers (remember GEICO-aka "The Security I Like Best" which was the lowest-cost provider and a high-quality business and one of his very first big investments in the '50s), and I don't think he'd be buying stocks at cheap multiples with the sole intent to sell them to someone else later at a higher multiple. In other words, regardless of the amount of money he has, I think Buffett would be viewing himself as an owner of a business and looking to create his returns through the operations of that business over time, and not necessarily relying on the market to assign a higher multiple to his holdings.
To Sum It Up
This post started with the idea to highlight a few outstanding historical bank stock investments, but I had a few comments on Buffett as well as the idea of buying cheap banks vs. quality banks. This post meandered a bit, but it's an interesting topic to me so I thought I'd write down some more thoughts. I've been spending a lot of time looking at a number of different opportunities in the banking industry lately, and I have a lot to say, but we'll have to focus on one thing at a time and save the other thoughts for later.