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Warren Buffett's favorite bank isn't like the others

May 20, 2014: 1:23 PM ET
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3 of these banks are kind of the same. Can you guess which one doesn't belong here?

The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney, Abbott Laboratories and AbbVie, La Monica does not own positions in any individual stocks.

Let's play a game. Please look at the image above and sing the following tune. Apologies to Sesame Street purists ...

One of these bank stocks is not like the others. One of these bank stocks just doesn't belong. Can you tell which bank stock is not like the others by the time I finish my song? Did you guess which bank stock was not like the others? Did you guess which bank stock just doesn't belong? If you guessed Wells Fargo is not like the others, then you're absolutely ... right!

Shares of Wells Fargo (WFC) are up about 8% so far this year. That's laudable in a rocky market. But it's even more impressive when you consider the awful performance of other big bank stocks.

  • Citigroup (C): Down 11%
  • Bank of America (BAC): Down 7%.
  • JPMorgan Chase (JPM): Down 8%.
  • Goldman Sachs (GS): Down 12%
  • Morgan Stanley (MS): Down 5%.

What's going on? While investors in other bank stocks are pulling a Kermit The Frog and complaining about how it's not easy being green in 2014, the Wells Fargo stagecoach has continued to roll along because it isn't like most other big banks.

Even though Wells Fargo is now the largest bank in the country by far as measured by market value (it's worth $50 billion more than JPMorgan Chase) its business model is more like an old-fashioned savings and loan than a Wall Street titan.

Related: Wall Street's profit troubles will continue

Wells Fargo generated less than a third of its total profits in the first quarter from its so-called wholesale banking unit. That includes investment banking and trading. Revenue and net income both declined in that business from a year ago.

But that was more than offset by a 30% increase in profits for the company's massive community banking franchise -- mortgage lending, credit cards and the mundane business of accepting deposits and servicing checking accounts. Wells Fargo makes more than half of its profits from Main Street style banking.

Compare that to JPMorgan Chase. Jamie Dimon's bank is more about catering to the 1% than the little guy. Nearly half of its profits in the first quarter were derived from corporate and investment banking as well as commercial lending.

The story is similar at Bank of America and Citigroup. Both rely more heavily on non-traditional banking businesses than Wells Fargo. And let's be honest. Goldman and Morgan Stanley are really bank holding companies in name only.

In addition, once interest rates finally begin to rise (the Federal Reserve can't stay in easing mode forever) then profit margins for Wells Fargo's bread-and-butter banking businesses should improve.

The tried and true model for banks is to take in deposits at a relatively low level and lend it back out at a higher level. The difference, or spread, is where banks make their money.

Related: Buffett wishes he bought more banks following the 2008 crisis

It's deceptively simple. And boring ... which is probably a key reason investing legend Warren Buffett is a huge fan of Wells Fargo. The bank is Berkshire Hathaway's (BRKA) (BRKB) largest holding.

That's why one fund manager who owns the stock thinks Wells Fargo may be the best financial stock to own if you truly believe in a long-term rebound for the housing market and American consumer.

"Wells Fargo is a way to bet on a substantially better economy over the next 10 years and a recovery in interest rates," said Bill Smead, manager of the Smead Value (SVFAX) fund. "It already controls a large part of the nation's mortgage and auto loans. The combination of loan growth and higher spreads is probably why Buffett loves it so much."

Speaking of Berkshire, that stock has been solid this year too. And investors in one of the most popular financial service sector exchange-traded funds must be glad about that. Wells Fargo and the Berkshire B shares are the two top holdings in the Financial Select Sector SPDR (XLF) ETF.

The ETF is flat in spite of the lousy returns from almost all the other big banks.

Wells Fargo has several other things going for it.

The bank didn't bomb the Fed's stress tests like Citi did. It also didn't have to rejigger its capital plan due to a math error like BofA did. Wells Fargo was already one of the higher-yielding bank stocks heading into the stress tests. Its dividend now yields nearly 3% following a 17% hike in the quarterly payout last month.

Related: Citi's capital plan rejected by the Fed

What's more, Wells Fargo announced at its investor day Wednesday that it was increasing its payout ratio target -- the amount of money that it feels it can give back to shareholders through stock buybacks and even higher dividends.

But if there is a negative for Wells Fargo, it is clearly its valuation. The stock trades at a premium to all of its peers on a price-to-earnings and book value basis. In other words, the market already knows that Wells Fargo is the best of the bunch. So if you want to own quality, you have to pay up for it.

Some value investors may argue that the other banks are now better bargains. After all, the best time to buy bank stocks is when they are hated. But the woeful performance of the group this year shows that many investors still don't trust the numbers coming out of Wall Street's biggest institutions.

In a research note Wednesday, Baird banking analyst David George wrote that he felt Wells Fargo's valuation was justified because of the bank's "best-in-class track record."

George added that as a result of Wells Fargo's crisis era acquisition of Wachovia, the bank can generate superior returns because its "deposit franchise is now one of the largest and among the most attractive in the country."

To wrap up with one more Sesame Street reference, other big bank stocks may be trash that only Oscar the Grouch could love. Wells Fargo is the one stock in the sector that doesn't have that much of a stench emanating from it.

And if you've made it this far, congratulations. Your reward? Cookie Monster singing One of These Things. Enjoy. C may be for Cookie. But it's also for Citigroup!

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Paul Lamonica
Paul R. La Monica
Assistant Managing Editor, CNNMoney

Paul R. La Monica is an assistant managing editor at CNNMoney. He is the author of the site's daily column, The Buzz, and also tweets throughout the day about the markets and economy @LaMonicaBuzz. La Monica also oversees the site's economic, markets and technology coverage.

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