The other day, I said that I had purchased Wells Fargo to the tune of 10% of the F Wall Street portfolio. As it continued to sink, I made another purchase in the $16s to bring the total Wells Fargo investment back up to 10% of the portfolio's assets.
The natural question, of course, is: Why? Why a bank? Why Wells Fargo? And why now?
Buying Banks During The Credit Crisis
We all know the old Buffett saying: Be fearful when people are greedy, and be greedy when people are fearful. Then there's the old adage: Buy when there's blood in the streets. Then, there's this one: You pay a very high price in the stock market for a cheery consensus — the title of a 1979 Forbes article by Warren Buffett.
In that article, Buffett wrote:
A second argument [of why stocks should be avoided] is made that there are just too many question marks about the near future; wouldn't it be better to wait until things clear up a bit? You know the prose: "Maintain buying reserves until current uncertainties are resolved," etc. Before reaching for that crutch, face up to two unpleasant facts: The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.
In closing, Buffett wrote:
There may well be some period in the near future when financial markets are demoralized and much better buys are available in equities; that possibility exists at all times. But you can be sure that at such a time the future will seem neither predictable nor pleasant.
That argument was true in 1979; it was true in 1974; it was true in 1987; it was true in...well, you get the idea. The only way to really buy when there's blood in the streets is to buy when the future seems unpredictable and unpleasant. If you "wait it out," you are almost certain to grossly underperform the markets...and even bonds...over the long-term.
Predicting The Future When The Future Is Unpredictable
If you read the aforementioned Buffett article carefully, you'll notice that he talks about the market's unpredictability. Over the long-term, American businesses will grow, even if (or though) the short-term market and business pain is severe and prolonged. The key, then, is to invest in businesses that will grow over the long-term at times when the short-term market and business pain is severe.
Obviously, not all of your investment decisions need to be in companies that are taking a ruthless beating. But...when looking for opportunities, well, you pay a very high price in the stock market for a cheery consensus.
Mr. Market — The Bank Bully of 2007...2008...2009...
When the stock market is feeling depressed, he (Mr. Market) can get downright mean. Over the past two years, he's been an utter bully to bank and financial stocks. In some cases, Mr. Market's quick and harsh temper is well guided. Sometimes, he's just being a jerk.
Right now, Mr. Market is trying to figure out whether or not the U.S. banking system will survive. On the one hand, he believes that virtually all banks should be nationalized, thereby wiping out shareholders and sending their stock prices plunging. If that's not bad enough, he believes that the entire U.S. is on the verge of collapse.
I've said it before — if the entire country collapses, the least of your problems is losing money in the stock market:
[The world] will still be here tomorrow. And you have to invest the same way for one simple reason: If everything does go to hell in a hand basket and the US (or your home) economy — and every business in it — fails, your money is worthless anyways.
So, we look to where Mr. Market is venting his anger...fear...frustration. And there, we find banks.
Why Wells Fargo? Candid Management.
In the banking sector, you'll be hard-pressed to find a management team as open and owner-oriented as the one at Wells Fargo. To get a better idea of this management-shareholder "partnership," take a look at their annual reports. Each one starts roughly the same way:
To Our Owners. Here's what we did well; here's what we did poorly. Here's why...and what we're doing about it.
As a side-by-side comparison, take a look at the cheerleader language of Bank of America's 2006 annual report vs. that of Wells Fargo in the same year.
They both start the same way: We had a great year. Here's what we accomplished. BofA leaves it at that; Wells Fargo talks about where it went wrong and what it is doing to become even better.
I'm not saying that Bank of America is bad; however, as an owner, I'd rather get a little more straight-talk from management.
Why Wells Fargo? Stable Business.
In this credit crisis, nothing is predictable on a day-to-day basis. Will housing bottom? Will write-offs get worse or is the worst behind us? What news is "priced in" and what is still debatable? If you're trying to outsmart the markets on a daily basis, you need to predict tomorrow before everyone else does.
About the only thing we do know with a degree of certainty is that the big banks had more write-downs leading up to their earnings announcements this month.
The question we need to ask: What banks will survive through this mess and be bigger five- and ten- years from now? If we can figure that out, and if we can make a smart purchase today, it doesn't matter if Wells Fargo lost $10 or $10 billion last quarter. We're looking forward.
Prior to its acquisition of Wachovia, Wells Fargo had three "segments" to its business:
Community Banking Group. Basically, the "bank" in the traditional sense of the word, serving consumers and small businesses with everything from checking accounts and mortgages to mutual funds and IRAs.
Wholesale Banking Group. The "institutional" arm of their business. This segment handles their "large business" lending and financing, institutional money management (eg., pension fund management), and large real estate lending.
Wells Fargo Financial. Credit cards, auto loans, personal loans, and other "small" lending (relative to the Wholesale Banking Group). Think of this as the "personal credit" arm of the Community Banking Group.
Losses aside, the acquisition expands every one of these areas. Before we get to the losses, let's examine how Wells Fargo will likely be affected by the credit crisis in each of its core segments.
Community Banking Group
Mortgage losses happen here. If Wells Fargo made bad loans (which we know they did), they will take the losses or set aside a credit reserve for losses in this segment. Though the company has been increasing its credit reserve in the face of losses, this segment of its business has actually been growing.
You just have to look beyond the quarterly earnings.
Through September 30, 2008 (and we'll know more about the most recent quarter soon), revenue increased 14% to $7.20 billion in third quarter 2008 from $6.32 billion a year earlier. Temporary credit losses aside, WFC was able to grow revenue handsomely last year. Keeping in mind that management is shareholder-oriented and that they have a strong history of keeping expenses down, this revenue will eventually turn into cash, once they solve their credit problems.
Wholesale Banking Group
In this segment of the business, revenue fell 17% in the first three quarters versus the same time in the year prior. No surprise here—a portion of their revenues is derived from investment fees. When the markets plummet 40%, fees tend to follow.
The drop in revenue is no surprise as it is cyclical revenue that largely depends on how people feel about the markets. When the markets are high, this segment will do well; when they tank, this segment will probably perform poorly.
The wholesale banking group is small relative to the Community Banking Group—just $2 billion or so in annual revenues versus $30 billion or so in the Community Banking Group. So, no real cause for concern.
Wells Fargo Financial
Brining in about 15% to 20% of Wells Fargo's revenues, this segment reported flat revenues for the first three quarters of last year versus the same period a year prior.
Putting It All Together
All three segments took hits to earnings due to increased credit reserves for expected losses. Earnings aside (ignore them), in the toughest banking and credit environment we've ever seen, Wells Fargo has been able to grow its top line. Eventually, that will translate into wealth for shareholders, assuming the company survives.
Will it survive?
Had I posted this a few days earlier, I would have written that a wide-scale nationalization of US Banks was highly unlikely because it would have been a premature move, largely hyped by the media, based on the results of a few very large banks. Though it could happen at some point in the future, it won't happen today.
Wells Fargo is doing a great job keeping customers and increasing revenues. If this government-run bad bank idea goes through, things may be a little easier for Wells Fargo if it transfers some of its bad assets off the books. If it doesn't take advantage of the bad bank, it will have a tougher time; but, that's no reason to believe it won't be around and larger five and ten years from now.
How can I come to that conclusion? In the next post, we'll look at the Wachovia deal. For now, let's just say that Wells Fargo, without the Wachovia deal, could have built its credit reserves mostly from internally generated cash (unlike Countrywide, that probably would have died without Bank of America); so, this credit crisis appears to be a temporary strain on Wells Fargo, not a permanent set back, from which it will have to rebuild.
Will Wells Fargo be cheaper a week...a month from now? I have no idea. That fact was obvious because I reported our first purchase here at $23.41 and was, just four days later, down 41% on my original purchase. If I knew Wells Fargo would hit $13.74, I would have waited to buy it.
It doesn't change the fact that I believe that I made a smart purchase, even if I didn't bottom tick the stock.