Warren Buffett’s six best known bank positions have collectively outperformed the KRE regional banks index YTD in terms of total return, chiefly thanks to strong performance in Bank of America (BAC) and Bank of New York Mellon (BK). An equally weighted holding of each of Buffett’s names would have returned an investor 5% YTD, vs 0.6% for the KRE.
This isn’t a dramatic difference, you might point out. But that’s how Buffett does it. What can we learn from looking at his banks?
Whether you look at the median or the mean, Buffett likes his value. His banks are about 7% cheaper than the the top 20 banks excluding the ones owned by Berkshire. 2018 prospective growth is a bit lower, as it yield of the Buffett group.
All data in the valuation tables below uses Bloomberg consensus figures.
The value discount of the Buffett sample goes into double digits if you take out M&T Bank. But across the pack, Buffett’s getting very similar growth and yield to the opportunity set, and paying markedly less for it in terms of the multiple of earnings he holds these stocks at.
Which banks will win for Buffett in 2018?
Buffett won’t be thinking about this question but we mere mortals are allowed a little fun.
If there were to be an economic downturn, then I think that USBancorp (USB) and M&T Bank (MTB) would prove defensive and this portfolio would still outperform (especially if held on a straight average basis rather than weighted to market cap).
However, there is no reason to expect an economic downturn. The one area of the world economy seeing some marginal weakness is China, and the direct impact of Chinese GDP on the US is marginal. US and European data is encouraging.
More importantly, inflation poses no threat right now and this is usually how the US experiences a recession, when the Fed tries to induce a soft landing and causes a recession in the process. This isn’t of concern. So we can continue to ask which of this sample of banks will increase the most in value and think in terms of ongoing growth to frame this discussion.
BAC still looks good
The 2018 EPS growth for BAC is based on its strong buyback programme and its gains in operating leverage, with consensus now convinced of its ability to hit its 2018 $53bn core cost target. The same factors underpin the outlook for 2019 as well, by the way.
I think one source of Alpha in BAC that is now largely used up is its value discount. Consider it here alongside its large cap peers:
OK, there’s a bit left for 2019, if we are to insist that BAC should trade at the same forward consensus PEs as the more richly valued peers in the table. But the difference is now down to mid-single digits so it starting to look like a margin of error to me. Still, BAC should produce better EPS growth than these peers and probably has a little re-rating left.
WFC might surprise
Where I think Buffett may get a lot of juice in 2018 is from Wells Fargo (WFC). WFC has had a forgettable year so far with its reputational recovery ongoing and upward pressure on its efficiency ratio leading to some lacklustre numbers while many in its peer group have been posting markedly improved operating leverage and enhancing fairly stodgy top line growth in this way.
But, so what, you ask? WFC has the lowest growth of the bunch on a two year view. It’s on the same PE as JPM out in 2019 if consensus is right, where’s my alpha if I own it here?
The alpha should come from WFC’s re-rating as it gets its mojo back in terms of efficiency improvements and its customer care program wins more believers as it beds down. This is because WFC is probably worth a higher PE than the other large banks in that sample above.
To see why, consider WFC’s income structure in the chart below. There’s been a recent step down in non-interest income which is essentially a one off shift in mortgage banking fee income, which I’ve highlighted.
However, the stability and, importantly for PE ratios, the visibility of WFC’s income structure is obviously better than that of BAC, below, much as I continue to like BAC at the current level:
WFC has been re-engineering its software and branch network in 2017 and this has led to costs growing ahead of income, which has been beleaguered by the drop in mortgage banking fees I highlighted in the income chart for WFC and led to a lower operating margin. We see this below. The key point is that the cost growth should be finite, then the margin will pick up.
WFC will see this cost growth slow in 2018, and its revenue growth rates should improve as base income effects roll off through 1H18 and a rate hike in December 2017 gives a further boost to net interest income, which is growing steadily anyway.
This should allow WFC to regain a valuation premium over the likes of BAC.
Stay with BAC for its EPS growth and remaining valuation catch up such as it is. Stay with WFC for its prospective PE rerating as it gradually overcomes its problems and benefits from front loaded costs going into 2018.
Disclosure: I am/we are long WFC, C, BAC.
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.