Friday, December 28, 2007

Strong Banks are Very Cheap

This is the second part of a recent discussion between an old friend and client about the economy, markets, and interest rates.

Friend: So I think we both agree the subprime fiasco, while bad for housing and many banks, may not spill over as far into the overall economy as investors and the media now believe. If that is the case, what do your valuation models now say about stocks in general? I guess I'm particularly interested in the real bargains you might be finding.

GCD: We actually see bargains across almost all industry sectors, as well as, international stocks. But if you want to go where the bargains are, you go straight toward where the damage is the greatest: Financials. We still have to get through mid-January when all the banks and insurance stocks will be going to confession again, but if you stick to the highest quality institutions around the world, we believe their writeoffs will be well contained within their present capital structures, and if not, all they have to do is ask their friends in Asia for a little help. Selective banks are very cheap. Let's look at one in particular.
Wells Fargo is arguably the strongest bank in the US. They have a high double AA financial strength, a strong growth record, and enviable returns on total assets and equity. Finally, their largest shareholder is Warren Buffett, who would probably buy the bank and put in his hip pocket if they would let him. Thus, capital for expansion is not an issue.
The reason Mr. Buffett would buy WFC in a heartbeat is the chart above. It shows the comparison of WFC's dividend yield vs. the yield on a 10-year T-bond over the last 20 years.
The chart speaks a simple reality: 20 years ago there was nearly a 4% difference between the bond yield and WFC's dividend yield. Today it is zero, nada, zip.
20 years ago investors were betting that WFC's dividend growth would be at least 5% over the coming 10 years. If growth would not have been at least that much, the bond would have been a better buy by a wide margin. Indeed, over the last two decades WFC has grown its dividend in the low double digits and its stock has achieved a similar rate of return, beating bonds by a big margin.
Today, with WFC's dividend yield and T-bonds yielding the same, investors appear to betting that WFC will have zero growth over the next few years. That is hogwash. WFC will grow at least as fast as nominal GDP, which we estimate will run in the 5.5% - 6.0% range.
Almost all banks are as cheap as WFC. Some deserve their low prices, but a handful, at a minimum do not. Others that appear oversold to us are Bank of America and US Bancorp.
Banks have certainly made a wrong turn and now find themselves out wandering around in the weeds, but bad times for the average bank means good times for the big, financially strong banks such as WFC, Bank of America, and US Bancorp. With so many banks out in the weeds, these three big banks, along with a short list of foreign banks will gain market share over the coming years at an unprecedented rate.
Next time I'll discuss some other industries that look good to us.
We own all three of the banks discussed here, plus others.