Weekend thoughts: Buffett's Wells Fargo Opportunity Cost $WFC
I’ve been thinking a lot about the concept of an opportunity cost stock.
I’m pretty sure the concept, as with so many things, comes from Buffett. I believe a decade ago he explicitly said that Wells Fargo was his opportunity cost for buying a new stock (i.e. for every opportunity he looked at, he weighed buying the new stock versus simply buying more Wells). I can’t find the exact source for him saying that, and I know it sounds crazy that Buffett once spoke so highly of Wells given all the various scandals at Wells plus Berkshire completely exiting the stock a few years ago….. so as proof that my memory isn’t completely shot I’d point you to this interview in 2011 (where Buffett talks about buying more WFC month after month and year after year because the business will always be better five or ten years down the line) as well as this Munger quote (from Joys of Compounding book; not sure the original source)
When someone presented a company in an emerging market to Warren Buffett, Warren said, “I don’t feel more comfortable [buying this] than I feel about add-ing to our position in Wells Fargo.” He thinks highly of the company and the managers and the position they were in. He was using this as his opportunity cost. He was saying, “Don’t talk about anything unless it’s better than buy-ing more Wells Fargo.” It doesn’t matter to Warren where the opportunity is.
Speaking of Wells Fargo, it is pretty crazy how much time has changed. From 1994-2014, Wells Fargo smashed the indices despite that time period including the biggest banking crisis since the Great Depression (the GFC in 08/09).
But, in the 10 years since, Wells Fargo has performed abysmally. The stock has badly lagged both the indices and financials; in fact, the stock has barely outperformed treasuries (and we were living in a zero interest rate world, so treasuries weren’t exactly a high bar!). Peer JPMorgan beat the indices nicely over the same time period; what’s crazy is that with the benefit of hindsight it’s tough to understand why Wells would underperform so badly. This is a bit of an oversimplification, but the past ten years have increasingly favored larger banks given their implicit government backstop and huge benefits to scale (leveraging tech and regulatory costs) that simply didn’t exist 20-30 years ago. Given that backdrop and the assets they started with, it’s honestly hard to understand how Wells could fumble the past decade so badly
I would be remiss if I didn’t mention one more thing: this underperformance could perhaps be an argument for valuations mattering. In 2014, Wells had a book value of ~$30/share and the stock was $45. Today, book is $46 and the stock is ~$50. So a lot of the underperformance has simply been caused by the multiple shrinking….. but still, even adjusted for multiple I think WFC really botched the past decade.
Anyway, let’s turn back to what this post is supposed to focus on: opportunity cost stocks. The concept of an opportunity cost stock is one that I used to dismiss. After all, everything in investing is opportunity cost: if you have a 5% position in Stock X, that’s 5% you can’t have in cash, or stock Y, bond Z, or an index fund. So given you’re always making trade offs and opportunities when establishing a portfolio, how does calling something your “opportunity cost stock” add anything?
But, as with so much Buffett does, the concept of an opportunity stock has increasingly come to resonate with me. It’s just an incredibly useful tool for building / running a concentrated investment book.
There are all sorts of interesting things about an “opportunity cost” stock and how to effectively implement an opportunity cost portfolio strategy; for example, when you decide something exceeds your opportunity cost stock’s return, does that mean it becomes your new opportunity cost? Do you sell the old opportunity cost stock and replace it completely with the new one?
And how do you determine your marginal opportunity cost stock? Why do you even chose one specific stock versus using an index as your opportunity cost? Is your opportunity cost stock your best long term hold? Or the stock you think has the best risk/reward right now? Or, say you run a 10 stock portfolio: is your opportunity cost stock your top position, or is it the tenth stock in that portfolio?
The answers to all of those questions are interesting, and they in part depend on each individual investor and their strategy. Maybe I’ll write about them in a later post.
But the thing I wanted to talk about in this post was Buffett’s choice of Wells Fargo as his opportunity cost stock and what you can learn from it.
It is important to note the strategy Buffett runs. Berkshire is an enormous company with a huge portfolio. He can’t trade in and out of stocks; in general, when he buys it’s sort of a one way ticket since he’ll generally move the stocks a decent bit on the way out, and he’s limited to a pool of very large cap stocks…. but Buffett also can and does buy whole businesses, and he clearly weighs buying a whole company (and controlling its cash flow!) versus his opportunity cost stock. So Buffett when Buffett is chosing an opportunity cost stock, he’s picking from a basket of maybe 100 different large cap stocks as well as the potential for buying whole private businesses (and keeping dry powder ready to be able to do that). Nothing ground breaking there, but still important to keep in mind. Also probably worth reviewing Berkshire’s 2013 13-F just to see the companies / stocks Berkshire was invested in and what he was weighing Wells against.
When I keep that in mind and think about Buffett discussing Wells as his opportunity cost, four things jump out to me (though the first two are much more important than the last two, IMO):
Timelessness: I believe the joke is that banking is the second oldest profession. It’s timeless. As long as there is an economy, there will be banks. Sure, technology can change banking around the edges, but Buffett could confidently predict that banking will be around 100 years from now. I think that’s important: he was running a buy and hold strategy, and he was choosing a business and industry that there was a good shot he could buy and hold forever.
Math / returns on equity: Over a long period of time, the returns from investing in a stock will begin to match / converge the returns on capital for the underlying business. The appeal of investing in a bank with a competitive advantage is that you should be able to guess their returns within a pretty narrow range. In the ~10 years from 2002-2012, WFC averaged a low teens return on equity (and, again, this time period included the GFC!). In a more normalized environment, thinking WFC could consistently do a mid-teens ROE given their competitive advantages, deposit base, and historical consistency wasn’t crazy. Combine that consistency with the timelessness of the business, and you could easily underwrite WFC to do double digit returns over a long, long hold period.
It’s interesting to think about these returns in relation to index funds. Index funds / the market have averaged ~8%/year over a very long period of time; if you pay ~2x book for a bank that can do 15% ROE for a long period of time, than the simple math of those returns say that you have to do better than the index over a long period of time. Now, the devil is in the details / being able to consistently do mid-teens ROEs over a long period of time, but it is interesting that Buffett never bought index funds or seemed to think of them as his opportunity cost. He seems to have zeroed in on a business where the math suggested over time he would inevitably do better than the market if he was correct.
Speaking of “consistently do mid-teens ROEs over a long period of time”, it’s interesting to look at WFC’s ROEs over the most recent decade; suddenly, instead of mid to high teens, WFC is hitting the low teens and then approaching 10% flat (and this is before COVID, so in a pretty good economy and after corporate tax rates got lowered!).
Capital returns: WFC didn’t just generate consistent profits. Given their size and regulatory limitations, WFC returned a ton of cash to shareholders, both through dividends and through share repurchases. Interestingly, capital returns can be both a blessing and a curse. On the good side: it’s always nice to get cash back! A commitment to returning cash is one of the easiest solves for empire building; if management is returning a serious amount of cash to shareholders, there’s not much left for them to play around with and invest at subpar rates of returns. On the other hand, if a business can earn a 15% ROE, you’d much prefer they retain all of their earnings and invest them at a 15% ROE than return cash to shareholders (this is one of the reasons Berkshire doesn’t pay dividends).
Consistency: Even during the GFC, Wells Fargo earned a profit. Buffett likes to be able to buy stocks and close his eyes for ten years; not having to worry about huge losses in down cycles / cyclicals certainly helps!
I’d guess Buffett has had three opportunity cost stocks over the past thirty years: Coke in the 90s, Wells in the 2000s, and Apple today. What’s interesting is all of these companies are insanely consistent. Every year, you could take the prior years earnings and add maybe 5%, and you’d come pretty close to guessing that year’s earnings. And the risk of any of these ever putting up a year of negative earnings is low: Wells was profitable through the GFC, and I doubt Coke has ever had a year of negative earnings!
Why do I mention those?
First, I think those points very much fit with Buffett’s style. Buffett was looking for large cap, liquid stocks he could buy and hold for the long term. An industry that has been around for hundreds of years (banking) and a franchise that had a proven ability to generate returns on equity well in excess of its cost of equity certainly fit that investing model, and not having to worry about unexpected losses / downcycles even in the worst of markets cuts off some of the left tail / go to zero risk.
Second, when I was thinking through this post, I tweeted out a quick thing about Buffett’s opportunity cost stocks and I thought the results were really interesting. A lot of people mentioned index funds, which are honestly probably the right answer (every stock should be compared to just buying an index fund and chilling). The most popular results on the individual stock side were the credit card companies (V, MA, AXP) or the larger tech companies (in particular, MSFT, META, and GOOGL. Interestingly, no one mentioned AAPL, which is a Berkshire holding and I suspect would serve as Buffett’s opportunity cost currently), and I think those stocks would generally fit into Buffett’s opportunity cost model. A lot of people mentioned coal companies, which I think are really interesting. They wouldn’t fit into Buffett’s opportunity cost model given the businesses are not timeless (coal will probably be around 10 years from now, but it might not be 100 years from now…. and, even it is, coal mines are a depreciating asset so today’s coal companies will not be tomorrow’s unless they go buy new mines / assets) and they’re quite cyclical (compare today’s profits with the losses from the late 2010s!), but given their low valuations and capital returns, coal could absolutely make sense as the “opportunity cost” for an investor pursuing a deep value type strategy. So I’d guess I’d just reemphasize: if you’re picking an opportunity cost stock, it needs to math your personal strategy. Coal wouldn’t ever be the opportunity cost stock for Buffett, but it very well could for a variety of investors.
Anyway, I’m going to wrap this post up here. I don’t have a hard takeaway or anything from it, but the concept of an opportunity cost stock is something I’ve been thinking about a lot recently so I wanted to share that thinking with you.
PS- I alluded to it earlier, but I did want to mention it one more time: it is wild how poorly Wells has done over the past decade and how much the story has changed. Again, a decade ago Buffett was talking about Wells as his opportunity cost and treating the stock as an inevitable, and the stock price is effectively flat over the past decade. And I say all that because of this: while the concept of an opportunity cost really intrigues me, the fact that the literal GOAT (Buffett) could pick an opportunity cost stock in an industry that he’s absolutely an expert in and have the stock be flat for a decade before he sells out does suggest that the concept of a permanent opportunity cost stock is very, very dangerous. While you should always be weighing buying new stocks against the opportunity of holding / increasing what you already own, you also need to be flexible with incorporating new information and willing to kill your own best ideas when the facts change!