Investing in Warren Buffett's Favorite Bank

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Warren Buffett is arguably the best investor ever alive, and he is particularly savvy when it comes to picking stocks in the financial sector, so the fact that he´s been materially increasing his position in Wells Fargo (NYSE: WFC) for a long time is something that deserves investor's attention. If it's good enough for Buffett, maybe it's good enough for your portfolio too.

A Strong Bet

In an interview with San Francisco Business Times in July of this year, Buffett was quite vocal about his views on Wells Fargo:

"I like Wells better than anything by far. We bought Wells this year. We've bought Wells month after month, well not every month, for a lot of years.”

Wells Fargo is currently the second biggest position in Berkshire Hathaway´s (NYSE: BRK-B) portfolio, and the company stands out like the only one to which Buffett has been adding on a recurrent basis until recently. Buffett has several investments in the banking sector, and other alternatives are clearly cheaper than Wells Fargo, so the Oracle of Omaha must have some strong reasons to prefer Wells over its competitors.

A High Quality Bank

One thing that sets Wells Fargo apart from its competitors is its superior risk management policies. It's not that the bank does anything too fancy, on the contrary: Wells is the only one among the “big four” which avoided excessive leverage and the abuse of derivatives which almost collapsed its competitors during the financial crisis.

As we can see from the chart comparing earnings per share for Wells Fargo versus Bank of America (NYSE: BAC), Citigroup (NYSE: C), and JPMorgan (NYSE: JPM), Wells is the only one who delivered a substantial increase in earnings per share over the last five years, with an increase of more than 33.6%. JPMorgan is barely in the positive at 8.8% while Bank of America and Citigroup are unlikely to bring their earnings back to pre-crisis levels for a very long time.

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Quality Means Growth

This is not only a matter of past performance and downside protection, quality can also mean better growth prospects in the banking business, especially in the current context in which most competitors are still trying to streamline their balance sheets while Wells can focus on expanding its operations.

Wells has lower funding costs than its competitors, and this means higher profitability. Besides, it provides the possibility to charge lower interest rates on its loans when it wants to compete with other banks in the hunt for business opportunities.

The bank has positioned itself as the market leader in mortgage lending over the last years, and it now stands in a privileged situation to reap the benefits of a real estate recovery in the long term. The company has increased its deposits substantially with the acquisition of Wachovia, and this is a big advantage when it comes to cross selling, something in which Wells Fargo specializes.

The Price is Reasonable

In terms of Price to Book Value – a measure usually used to value banks – Wells Fargo is more expensive than its competitors. However, the much higher Return on Equity ratio shows that the company has outstanding levels of profitability in comparison to other players in the sector. From a comparative analysis, Wells Fargo comes out like the higher price and higher quality bet in the sector.

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 A historical valuation analysis shows that the current valuation levels are materially below pre-crisis. I wouldn't assume that the stock will go back to a price to book value of 2.5 anytime soon, but it clearly doesn't look overvalued either.

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Bottom Line

Due to the soundness of its management and its lower financial risk, Wells Fargo is unquestioningly the high quality play among big banks. The company has superior profitability and better growth prospects than any of its peers, that's why Buffett likes the stock so much, and perhaps you should like it too.

acardenalowns shares of Wells Fargo. The Motley Fool owns shares of Bank of America, Berkshire Hathaway, Citigroup Inc , JPMorgan Chase & Co., and Wells Fargo & Company. Motley Fool newsletter services recommend Berkshire Hathaway and Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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