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Warren Buffett started building his holding in Wells Fargo in 1989 but it wasn’t until October 1990 the stake grew so large that he announced Berkshire Hathaway held 5m shares, almost 10% of its common stock, making it the largest shareholder. So, what was it that made Buffett go against the crowd and spend $289m on a bank facing a recession in its home market? The answers illustrate the importance of the qualitative – the fuzzy – in true investing, rather than the raw numbers.
Quality of managers
A few months after the announcement, Buffett’s letter in BH’s 1990 annual report set out some of his thinking. Wells Fargo was “a superbly-managed, high-return banking operation”. He then immediately highlights the dangers of investing in this sector “The banking business is no favorite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks.”
He wrote this in the midst of a humdinger of a recession. But he laid the blame for these failures squarely at the door of bank managers who follow the “institutional imperative”, mindlessly copying the behaviour of other bankers, even if that behaviour is foolish.
In my book The Financial Times Guide to Banking I warn readers not to think bank lending decisions are entirely rational. Many bankers seem to follow fashions as they come and go. They have a habit of rushing to one type of lending one year, say house mortgages, which then become under-priced and banks become over-exposed there, and then, in another year, hurling themselves at another sector, say warehouse builders or farmers. Buffett gloomily concluded in his 1990 letter that bankers, having played follow-the-leader “with lemming-like zeal; now they are experiencing a lemming-like fate”.
He noted that leverage of 20:1 had the effect of magnifying managerial strengths and weaknesses, with the implication that most banks in 1990 were beyond the pale and not to be touched, even if they appeared cheap.
But Wells Fargo was different. It was different in a way that you’ll not find on a spreadsheet or a database. The advantage lay in the fuzzy world of the qualities of people, “With Wells Fargo, we think we have obtained the best managers in the business, Carl Reichardt and Paul Hazen.”
In the banking sphere, these two were considered by Buffett to be as great as the combination of Tom Murphy and Dan Burke at Capital Cities/ABC in media. Three characteristics were possessed by both sets of partners:
- As a pair they were stronger than the sum of the parts because each partner understood, trusted and admired the other.
- They were very strict on costs, e.g. not having a larger staff than absolutely necessary. But they paid talented team members very well.
- They stayed within their respective circles of competence and let “their abilities, not their egos, determine what they attempt. (Thomas J. Watson Sr. of IBM followed the same rule: “I’m no genius,” he said. “I’m smart in spots – but I stay around those spots.”)”
Berkshire Hathaway purchased its 10% holding in Wells Fargo at a price about five times recent earnings after tax. Buffett pointed out, to perhaps sceptical BH shareholders, that the bank had been earning more than 20% on equity, implying that with such fine managers it will again achieve such returns once the recession was over.
There are risks in investing in any bank
But he wanted to prepare BH
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