Warren Buffett Is Right About Wells Fargo's Dividend

| About: Wells Fargo (WFC)
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Warren Buffett does not make prediction about a company's dividend policy too often, but he did in the 2010 Letter to Shareholders of Berkshire Hathaway (NYSE:BRK.B) when he made this prediction about Wells Fargo's (NYSE:WFC) future dividends:

"In addition, dividends on our current common stock holdings will almost certainly increase. The largest gain is likely to come at Wells Fargo. The Federal Reserve, our friend in respect to Goldman Sachs (NYSE:GS), has frozen dividend levels at major banks, whether strong or weak, during the last two years. Wells Fargo, though consistently prospering throughout the worst of the recession and currently enjoying enormous financial strength and earning power, has therefore been forced to maintain an artificially low payout. (We don't fault the Fed: For various reasons, an across-the-board freeze made sense during the crisis and its immediate aftermath.) At some point, probably soon, the Fed's restrictions will cease. Wells Fargo can then reinstate the rational dividend policy that its owners deserve. At that time, we would expect our annual dividends from just this one security to increase by several hundreds of millions of dollars annually."

After cutting the dividend from $0.34 per share quarterly to $0.05 in 2009, Wells Fargo has come roaring back with its stellar dividend growth since then. The dividend climbed to $0.12 per quarter in 2011, $0.22 per quarter in 2012, and has recently raised the dividend to $0.30 per share.

There is a reason why Wells Fargo has replaced Coca-Cola (NYSE:KO) as the largest holding in Berkshire's portfolio. Even counting the latest dividend increase to $1.20 annually, the company's dividend payout is still low (especially compared to the company's long-term targets, and we'll talk about that in a minute). In 2012, Wells Fargo earned $3.36 per share. The increased dividend payout is just 35% of last year's earnings. If the Value Line estimate that Wells Fargo will earn $3.70 per share this year turns out to be correct, then the new Wells Fargo dividend will be paying out 32.5% of this year's earnings.

The next four years may represent a golden age of dividends for certain high-quality banks (something I wrote about here two years ago when I stated the obvious that the bank payout ratios at Wells Fargo, JPMorgan (NYSE:JPM), and U.S. Bancorp (NYSE:USB) were incredibly low given the current and future earnings growth expectations). We are currently seeing Wells Fargo lead the charge by aggressively returning capital to shareholders via the dividend raise and a recently announced buyback program (the details of which have not been announced yet). The company has announced a long-range payout ratio target of 65%. In this case, payout ratio refers to both dividends plus buybacks, and the 65% target is contingent upon modest interest rate increases within the next 3-4 years.

From a dividend growth perspective, Wells Fargo shareholders may stand to benefit from two favorable forces: earnings growth matched by an accelerating payout ratio. The analyst consensus is that Wells Fargo will earn $4.30 in 2015/2016. If the company accomplished that and returned 45% of earnings to shareholders in the form of dividends, we are looking at $1.93 in annual dividends three to four years from now (the current hike has the payout at $1.20 annually).

But then again, this is the banking sector, and no one saw Wells Fargo's 75% profit decline in 2009 coming years in advance. That is something to keep at the back of your mind anytime you consider any meaningful financial sector investment. Banks are not the most resilient place to be during a sharp economic recession, and although Wells Fargo has strong advantages that result from dealing with high quality assets and being the low cost producer in the industry, the lofty dividend increases going forward are by no means guaranteed given that a deterioration in the housing market or overall economy would likely force Wells Fargo to retain capital as a buffer.

Despite this risk, Warren Buffett has positioned himself quite well with his Wells Fargo investment, particularly if there are modest or better economic improvements over the coming years. Berkshire controls 456,000,000 shares of Wells Fargo. With the current increase in Wells Fargo's dividend, Berkshire will now be receiving $550 million in Wells Fargo dividends each year, paid quarterly in $135-$140 million installments. Considering that Wells Fargo is expected to raise its dividend by 10% or more annually for the next 3-5 years, Buffett should get substantial raises in the amount of money funneling into headquarters going forward.

Buffett's successful investment in Wells Fargo provides a useful lesson for income investors because it demonstrates the benefits of not purchasing a stock necessarily with an eye on the current income, but with an eye on the future income and earnings that a potential holding will be generating 5+ years down the road. Buffett's recognition that Wells Fargo's earnings were temporarily depressed (and the dividend was artificially low as well) has fueled Berkshire's binge to now own almost 9% of the California lending giant. As Wells Fargo's recent earnings reports and dividend increases indicate, we are starting to see strong signals that Buffett exercised great judgment with his large purchase of Wells Fargo for Berkshire.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.