Will Warren Buffett sell Wells Fargo?

By Larissa Fernand |  07-10-16

Last month U.S. federal regulators unveiled that since 2011 Wells Fargo employees had secretly created more than 2 million unauthorized bank and credit card accounts — without their customers knowing it. In other words, the customers paid real fees for fraudulent accounts they had never authorized.

With Wells Fargo at the centre of the storm, all eyes are on Warren Buffett. Berkshire Hathaway owns 9.5% of the bank. Which begs the question, what will he do? Speculation is rife, all the more because Buffett has chosen to keep silent.

News reports quoted prominent Rafferty Capital analyst Dick Bove who is of the opinion that Buffett may head for the exit. Bove says it is no coincidence that while Wells Fargo CEO John Stumpf was getting grilled before the Senate Banking Committee, an announcement was made that Todd Combs (Buffett’s deputy) was joining the JPMorgan Chase board. That move could indicate that Buffett was walking away from Wells Fargo.

This addition to the board (JPMorgan Chase is one of Wells Fargo’s biggest competitors) eliminates the possibility of Berkshire scouting for representation on Wells Fargo board, because by law, banks are prohibited from having interlocking directorships.

Which brings us to a pertinent question: Does the scandal warrant a divestment by Buffett?

Wells Fargo got punched in the face and is nursing a black eye. The bank is no doubt experiencing a reputational crisis. And it did not help that Stumpf bristled during the Senate hearing that he “disagrees that this is a massive fraud.”

But, this is not just any bank. It is Wells Fargo. And Wells Fargo is a solid brand.

In fact, it is the most valuable banking brand across the globe. According to Brand Finance’s annual report on the world’s most valuable banking brands, Wells Fargo was No. 1 in 2015 (brand value = $34,925 million) and continued to hold that position in 2016 (brand value = $44,170 million).

In compensation for the scandal, the firm has agreed to pay $185 million in fines and set aside $5 million to refund customers. That seems like a lot, but look at it in comparison with its revenues. It had a net income of $5.6 billion for the second quarter of the calendar year (June 30, 2016). The bank rests on a solid foundation and its balance sheet strength is quite good.

Morningstar analysts believe that the bank’s dominant market position is its largest structural advantage. Wells Fargo is the largest deposit gatherer in major metropolitan markets across the country. It's long-standing focus on cross-selling helps lock in customer relationships and access to low-cost funding. The bank builds on its funding advantage through efficient operations and solid underwriting, minimizing costs at the same time it maximizes revenue associated with every dollar held on its balance sheet, garnering the firm a wide economic moat. Wells Fargo's exceptionally high levels of profitability are a result of its wide economic moat. (Read more here.)

With regards to the 5,300 employees who were shown the door as atonement for their misdeeds, the analysts looked at the Stewardship parameter. After a detailed study, they concluded that it was not cause for concern and the bank’s culture and management have generally done quite well for shareholders and customers over time.

Even Bove believes that the scandal will blow over and when talking to FOX Business he was of the opinion that what happened at Fifth Third will play out here too. Fifth Third ran into trouble several years ago and took a few years to straighten out, after which the company’s culture became more service oriented as opposed to sales oriented.

How does Buffett view Wells Fargo?

Buffett has been a long time owner of the stock. In a 1990 letter to shareholders, he explained how he began to pick up Wells Fargo in the midst of a chaotic market in bank stocks. Due to the savings and loan crsis, real estate prices were collapsing and lenders were taking a beating on their balance sheets and in the markets. He purchased 10% in Wells Fargo for $290 million, less than 5x after-tax earnings, and less than 3x pre-tax earnings.

In an interview with Fortune around 7 years ago, he said they were smart on the asset side and stayed out of most of the big trouble areas. The customer base grows quarter by quarter, and the bank makes money by having a spread on assets and not doing anything really dumb.

A few months ago, Buffett applied for regulatory approval to purchase more shares of the bank. A reflection of his conviction in the fundamentals of the financial giant. And who would deny that Buffett is an astute judge of value?

Buffett always looks through the drama and hype.

Let’s look at the precedent set by Buffett.

In 2011, he invested $5 billion in Bank of America despite the bank’s mortgage division racking up billions of dollars in legal bills, massive losses running into billions (owing in large part to a settlement with mortgage investors), non-core assets on the block and thousands of layoffs. Buffett’s explanation: “BoA is a strong, well-led company. I am impressed with the profit-generating abilities of this franchise, and that they are acting aggressively to put their challenges behind them. They are focused on their customers and on serving them well. That’s what customers want, and that’s the company’s strategy.”

Years before that, he trained his guns on Goldman Sachs when the industry was going through a period of immense trepidation following the collapse of Lehman Brothers and AIG. Buffett explained his steely-eyed decision to infuse $5 billion into the firm  by describing Goldman Sachs as an “exceptional institution, with an unrivaled global franchise, a proven and deep management team and the intellectual and financial capital to continue its track record of outperformance."

Buffett showed tremendous investing courage by throwing these lifelines at a time when the environment was clouded by economic concerns, global turmoil, regulatory uncertainty, and legal liabilities. Yet, he made money on these bets.

And, of course, who can forget the legendary “Salad Oil Scandal” of 1963 that resulted in American Express losing nearly $58 million. As Wall Street bailed for the exits on fears that the company would go bankrupt, Buffett bet 40% of his investment partnership’s capital on Amex. A decision he never regretted. (You can read the details here.)

This means………………….

One should not be surprised to see him pick up even more stock of Wells Fargo since he does make deft moves at the time of weakness. And he has a penchant for high-quality financial companies with a strong franchise and brand.

So maybe we should change the question.

Out: “Will Buffett sell the stock of Wells Fargo?”

In: “Will Buffett be buying more of Wells Fargo?”

After all, it was he who said: “The best thing that happens to us is when a great company gets into temporary trouble…We want to buy them when they’re on the operating table.

And he always puts his money where his mouth is.

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