Buffett Likes Banks

Buffett Likes Banks
By Alex Dumortier, CFA
March 11, 2009 Comments (3)

When Warren Buffett speaks, the market listens. On Monday, in a three-hour interview on CNBC, Buffett had some good things to say about the banking sector. That was all the fuel that was needed for some of the bank stocks to take off:

Bank
Daily Return (03/09/2009)

Bank of America (NYSE: BAC)
19.4%
Wells Fargo (NYSE: WFC)
15.8%
US Bancorp (NYSE: USB)
15.5%
SunTrust Banks (NYSE: STI)
7.8%
BB&T (NYSE: BBT)
4.1%

Some of the best gains were naturally reserved for stocks that Buffett owns on behalf of Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B): US Bancorp and Wells Fargo.
"Banking has never been better, in one sense." Spelling out the reasons for his cheery disposition toward the sector in straightforward terms, Buffett said:
The banks are getting their money very cheaply, deposits are coming in, spreads have never been wider, all the new business they're doing is terrific. They will earn their way out of it [in the] overwhelming number of cases.

He went on to give specifics concerning Wells Fargo:
I would expect $40 billion a year pre-provision income. And under normal conditions I would expect maybe 10 to $12 billion a year of losses … So, you know, you get to very interesting figures.
What could Wells earn a few years out? Those numbers are pretty close to the results that Wells put up last year (which don't include Wachovia), so I'm going to assume that Buffett was referring to Wells Fargo's earnings power without Wachovia.
Let's accept those numbers (using the upper bound for loan losses) and make the following assumptions:
Wachovia provides an incremental $3 billion in net income.
The merger achieves the announced $5 billion in cost savings.
Wells Fargo doesn't repay the government's $25 billion preferred share investment.
Under that scenario -- that of a normal operating environment -- I estimate that Wells Fargo could generate approximately $2.50 in earnings per share annually. Based on Monday's closing price of $9.97, that's equivalent to a price-to-earnings ratio of 4 -- pretty attractive!

Let's remember a couple of things, though: First, we aren't in a normal environment yet, and it's not clear how long it will take us to get there. Second, there is a reason that bank shares are trading at such depressed valuations. As Buffett pointed out:
"The only worry in that is the government will force you to sell shares at some terribly low price." He went on to admit that forced dilution isn't an idle concern -- it's something that he himself thinks about. Furthermore, even the Oracle has been bitten by banks in this crisis. In 2008, he purchased $244 million worth of shares in two Irish banks, leaving him with an 89% loss at year's end. He gave himself a stern self-assessment on that situation during the interview: "I did not do my homework sufficiently on that, and I was just dead wrong."

Nonetheless, Berkshire is Wells Fargo's largest shareholder -- the position dates back to the last banking crisis in the early 1990s. In other words, Buffett's been doing his homework on Wells Fargo for a long time, and his degree of confidence should be much higher. I have to go with Buffett on this one: Despite my concerns about the California lender, I think it looks like a good bet right now.

More Foolishness:
Are GE Shares Finally a Buy?
10 Dividend Stocks for the Next Decade and Beyond
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Take a hint from Buffett's recent investments in preferred shares with fat yields: In this market, dividends -- those that are sustainable -- will be a big component of future shareholder returns.


Alex Dumortier, CFA has a beneficial interest in Wells Fargo and BB&T, but not in any of the other companies mentioned in this article. BB&T is a Motley Fool Income Investor pick. Berkshire Hathaway is a Motley Fool Inside Value and a Motley Fool Stock Advisor recommendation. The Fool owns shares of Berkshire Hathaway. US Bancorp is a former Motley Fool Income Investor pick.

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