Old Fashioned Banking Still Works

Daniel is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Carla Fried made an excellent observation last weekend: Of the changes to Berkshire Hathaway's investment portfolio revealed in a recent filing, why is Buffett's addition of John Deere receiving all the attention? More deserving of the limelight, the filing also revealed that he added 11.5 million shares of Berkshire's second largest position of all: Wells Fargo (NYSE: WFC), making up a whopping 19.5% of Berkshire's $75 billion investment portfolio. Even more impressive, Berkshire's stake in Wells Fargo has grown grown by 45% in 2012 alone. And let's not forget that Buffett told CNBC that he picked up even more shares of Wells Fargo in October amidst a sell-off. So, what's so special about Wells Fargo? Turns out that traditional banking still works–and it works great.

Off-Balance-Sheet Activities

Carla did an excellent job on her article covering some reasons why Wells Fargo is a standout bank, but I'm going to take it a bit deeper. We'll start with off-balance-sheet activities. Off-balance-sheet activities simply refer to earnings derived from items that are not on the balance sheet. They've grown in importance over the years, nearly doubling as a percentage of banking assets since 1980.

What differs, however, is how banks have decided to approach these activities. Some banks still duke it out the traditional way–with fees. Many banks, like JPMorgan Chase (NYSE: JPM) have chosen to take on an increasing amount of risk in their off-balance-sheet activities in pursuit of greater profits by engaging in a large amount of derivative dealings. Wells Fargo, on the other hand, has a higher reliance on fees and a small fraction of derivative dealings compared to the figures reported by JPMorgan Chase.

There are two ways in which banks can approach these off-balance-sheet trading activities: (a) In an attempt to reduce risks or (b) to engage in the outguessing game, attempting to engage in speculation. Speculation is, of course, very risky. Wells Fargo tends to stray away from the speculation, making its earnings more predictable for investors like Warren Buffett.

Cheap Liabilities

One of the fundamental principles of bank management is liability management. The cheaper banks can acquire liabilities, the better. Just like a home-owner who seeks out the lowest interest loans, banks want to pay as little interest as possible on their liabilities.

Just imagine acquiring a loan at a 0% interest rate. Checkable deposits, the majority of the time, are an interest free liability to banks (or close to it). Of course they have to pay the fees associated with maintaining deposits for customers, but this expense is minimal.

Wells Fargo happens to be the largest deposit gatherer in the US in major metropolitan areas. This scale results in increased convenience for its customers and it increases switching costs. But even more importantly, these deposits give the firm over $90 billion in low-cost liabilities. The ratio of these low-cost liabilities to Wells Fargo's total liabilities is 78%, the envy of the industry. This enables Wells Fargo to fund its assets at a cheaper rate than any of its competitors.

Since the majority of Wells Fargo's deposits come from customers in regions in which the bank is a dominant player, convenience and higher switching costs make these deposits more reliable than deposits at other banks. Liabilities, of course, are what enable banks to create income-generating assets; banks keep a certain percentage of deposits on hand and loan out the rest. So, more reliable, lower-cost liabilities result in more consistent income-generating assets for Wells Fargo shareholders.

Consistency of Profits

Conservatism, and old-fashioned banking spill over into consistent profits that make forecasting future cash flows easier. Check out Wells Fargo compared to some of its peers measured by earnings per share (EPS) over the past ten years:

<img src="http://media.ycharts.com/charts/5dd45d3844aec0f4f1e399a25652be89.png" />

WFC EPS Diluted TTM data by YCharts


As always, Buffett is a bargain hunter. His thoughts regarding Wells Fargo's intrinsic value probably haven't changed much. His additions to Berkshire's Wells Fargo position are probably mostly due to a falling stock price:

<img src="http://media.ycharts.com/charts/6495843bb6615c7647de94cdfd6064a4.png" />

WFC PE Ratio TTM data by YCharts

The Bottom Line

Wells Fargo's straight-forward, old-fashioned banking business model, with an emphasis on fees, risk management, and cheap liabilities make Wells Fargo a more reliable and predictable investment than other banks. It's no easy feat to acquire low-cost liabilities through deposits like Wells Fargo has. This is true evidence to formidable management. I'd say Buffett's recent additions to his Wells Fargo position and a recent sell-off merit the company at least a position on your watchlist.

DanielSparks has no positions in the stocks mentioned above. The Motley Fool owns shares of Berkshire Hathaway, 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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