Whenever investors discuss the array of investments that Warren Buffett has accumulated in Berkshire Hathaway’s (BRK.A) $52 billion portfolio, they sometimes reach the conclusion that the stocks in Buffett’s arsenal are automatically ‘a buy.’
Sure, buying any of the companies that Buffett owns will probably put you in decent shape if you’re a long-term buy-and-hold investor. But I think we should keep in mind that Buffett doesn’t simply jump in to companies that he likes—instead, he gobbles up shares of those companies if, and only if, they are selling at the right price.
For instance, Buffett’s most iconic holding is probably his 200,000,000 share investment into Coca-Cola (KO). At yesterday’s closing price of $69.68 per share, that would put his Coca-Cola investment at just shy of $14 billion. Clearly, he has put quite a bit of faith in the stock. But if he’s not using Berkshire’s $40 billion cash holdings to purchase more shares of the company, it’s most likely that he thinks either:
(A) Coke will not deliver the superior returns he seeks based on today’s market prices.
(B) there are other large-cap investments out there that offer greater value than Coke.
Instead of looking at what Buffett holds, we can get a much better indication of what Buffett thinks about current market prices by looking at what he has bought in the most recent quarter. The most striking news from his Q2 report is that he loaded up on even more shares of San Francisco-based lender Wells Fargo (WFC). He purchased 10,000,000 shares of WFC in the second quarter, and looking at the average price of WFC stock during that time frame, we can make the educated guess that he paid about $28 each for the shares.
For those of you out there with long memories, it may seem that history is repeating itself. About 20 years ago, Buffett began gobbling up shares of Wells Fargo when most financial analysts were trashing the stock because of the company’s large exposure to the mortgage market. Sound familiar?
And in 2009, Buffett sat down with Fortune Magazine editor Adam Lashinsky to discuss the rationale for accumulating such a large position in Wells Fargo. And here’s what Buffett had to say:
In the end banking is a very good business unless you do dumb things. You get your money extraordinarily cheap and you don't have to do dumb things. But periodically banks do it, and they do it as a flock, like international loans in the 80s. You don't have to be a rocket scientist when your raw material cost is less than 1-1/2%. So I know that you can have a model that works fine and Wells has come closer to doing that right than any other big bank by some margin. They get their money cheaper than anybody else. We're the low-cost producer at Geico in auto insurance among big companies. And when you're the low-cost producer - whether it's copper, or in banking - it's huge.
Then on top of that, they're smart on the asset side. They stayed out of most of the big trouble areas. Now, even if you're getting 20% down payments on houses, if the other guy did enough dumb things, the house prices can fall to where you get hurt some. But they were not out there doing option ARMs and all these crazy things. They're going to have plenty of credit losses. But they will have, after a couple of quarters of getting Wachovia the way they want it, $40 billion of pre-provision income.
And they do not have all kinds of time bombs around. Wells will lose some money. There's no question about that. And they'll lose more than the normal amount of money. Now, if they were getting their money at a percentage point higher, that would be $10 billion of difference there. But they've got the secret to growth, low-cost deposits, and a lot of ancillary income coming in from their customer base.
If Buffett was buying Wells Fargo during the second quarter when it was trading around $28 per share, we can probably make a pretty good guess about what is on Buffett’s radar now that Wells Fargo is trading between $23 and $25 per share. Of course, long-time WFC investors may still be feeling betrayed after Wells Fargo cut its dividend in 2009 from $0.34 per share to a nickel.
While I understand perfectly well and sympathize with dividend-seeking or retirement-focused investors who feel spurned by that move, we should be asking ourselves, “What is the outlook for Wells Fargo at today’s prices?”
Wells Fargo has historically paid out half its earnings to shareholders as dividends. Over the past years, WFC has earned $2.58 per share. After more than doubling its dividend from $0.05 to $0.12, Wells is still only paying out $0.48 per share in dividends. While I do think that the new capital requirements will decrease the likelihood of WFC paying out ½ its earnings as dividends, I don’t think a rate of 35% would be an unreasonable assumption.
That would imply that Wells Fargo would come close to doubling its dividend again, paying about $0.22 per share. At today’s prices, that would give you a dividend yield of 3.6%, which I think is a quite conservative estimate because I’m not even pricing in growth. If Wells could grow earnings by 6% annualized for the next five years, it would be earning $3.45 per share, and if they paid out 35% as dividends, you would be receiving a payout of $1.20 per share.
Considering this is a rather conservative estimate of realistic scenarios, I would think that investors who initiate a position in Wells Fargo today will be happy with the results five years from now.