Warren Buffett's 2 Favorite Banks Look Compelling

| About: U.S. Bancorp (USB)

Summary

Warren Buffett and Berkshire Hathaway are associated with a variety of financial companies.

This article talks about perhaps his two “favorite” positions.

Each is offering a “low bar” investment based on a few assumptions regarding the future prospects of the businesses.

It's no secret that Warren Buffett has an affinity for owning bank stocks. As far as the largest of banks are concerned, a couple years ago Buffett indicated that he had a personal sake in JPMorgan (NYSE:JPM). For his Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) conglomerate, Buffett owns billions in Bank of America (NYSE:BAC) warrants.

If you were to search the latest company filing Berkshire has stakes in smaller banks like Bank of New York Mellon (NYSE:BK) and M&T Bank (NYSE:MTB), to go along with other financial firms like American Express (NYSE:AXP), MasterCard (NYSE:MA), Visa (NYSE:V) and Goldman Sachs (NYSE:GS). The industry seems to fit his model well and Berkshire hasn't been shy about owning large chunks of these types of companies.

Of course we haven't yet talked about perhaps Buffett's two "favorite" bank holdings: Wells Fargo (NYSE:WFC) and U.S. Bancorp (NYSE:USB). Excluding the Bank of America warrants, these are the two largest bank holdings within Berkshire Hathaway's publicly traded portfolio. As of the last filing, Berkshire owned nearly 480 million shares of Wells Fargo (worth $23 billion or so) and 85 million shares of U.S. Bancorp (worth $3.4 billion or thereabouts).

What's interesting to me is that despite the much higher share prices in the last few years, both of these securities could still be "low bar" investment opportunities. Let's work through an illustration to get a better idea of what I mean.

Here's a look at some basic information that you might see from a financial website:

Incidentally, with this information in hand you can also figure out the payout ratio. You simply multiply the P/E ratio by the yield and can see that Wells Fargo is paying out roughly 36% of its earnings in the form of dividends, while U.S. Bancorp is paying out about 33% of its profits as cash payments.

To give you some context, over the past decade shares of Wells Fargo have traded with an average earnings multiple (excluding the recession) of about 12, an average dividend yield of ~2.5%, and a payout ratio of roughly 34%. So today's valuation and dividend yield is slightly lower and its payout ratio is slightly higher (although to be sure this was artificially low coming out of the recession).

During that same time (and excluding the recession), shares of U.S. Bancorp have traded with an average earnings multiple of about 13 and a dividend yield of 2.7%. The average payout ratio was about 37% during this time. Although keep in mind that the payout was much higher prior to the recession and much lower thereafter.

So in comparison to each securities' past, today's valuation is more or less on par with the historical average. Now let's see if we can develop a potential "base case" for each investment moving forward. Obviously the future is unknown, but you have to come up with an expectation. Here's what that could look like over the next five years:

For the estimated earnings growth, I looked around and found intermediate-term growth estimates ranging from 5% to 10%. Then in the second column I supposed that each company was able to grow it's per share earnings by the low-end of the growth estimate - so 6% for Wells Fargo and 5% for U.S. Bancorp. Naturally there are a wide range of possibilities that are much higher or lower, but the idea is to get a baseline (and hopefully stay somewhat prudent in doing so.)

The future P/E assumed that the historical average more or less stays intact, with the future price being the product of the EPS estimate and the earnings multiple. That's one side of the equation. It gives you an exact, to the penny, share price expectation, but I'd contend that this is merely a starting point. Instead of thinking about $66.64 exactly, ideally you'd like to think about $60 to $70, or an even wider range. The concept is to develop a thesis and leave room fluctuations.

Next we can add in dividends:

Here I used an ending payout ratio, after five years, of 40%. This implies a dividend growth rate for each company in the 8% to 9% range. This is a bit higher than what has occurred recently, but I do not believe it's a large leap over the long-term. Once more a specific number is given, but keep in mind that this is just a baseline. Whether the actual dividends received add up to $9 or $10 for Wells Fargo, the general concept is quite similar.

In that spirit, I'll demonstrate the annualized return without using precise numbers. If the above assumptions were to come to fruition for Wells Fargo - 6% EPS growth, a future P/E ratio of 12 and a 40% dividend payout ratio - your total expected value would be about $76. Expressed differently, you would anticipate a total annualized gain of about 9.6% over the next half decade.

If the U.S. Bancorp assumptions were to formulate - 5% EPS growth, a future P/E ratio of 13 and a 40% dividend payout ratio - your total expected value would be about $58. On an annualized basis, this equates to a total return of 7.4%.

This is what I mean by a "low bar" investment. Naturally you can argue over the merits of any one of those assumed metrics above. However, I don't think they are exactly exceptional either. It's not like you need 15% earnings growth to justify the current valuations or are hoping the P/E ratio jumps to 20.

Instead, you would be assuming that earnings growth comes in on the low end of expectations, with a future multiple below 14 and a payout ratio under 50%. Those aren't large suppositions to make, and yet investors could still see 7% to 10% annualized gains. It's the sort of thing that could turn a starting $1,000 investment into $1,400 or $1,600 after five years. And naturally if things turn out better than expected you could move from reasonable to substantial returns rather quickly.

Disclosure: I am/we are long WFC, BRK.B.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.