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The Warren Buffett Bull Case For HSBC Holdings plc

Many investors who focus on a low price-to-earnings (P/E) ratio and high dividend yield in their search for value will have a hard time swallowing the maxim legendary investor Warren Buffett lives by: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.

Today, I’m considering whether FTSE 100 banking giant HSBC (LSE: HSBC) (NYSE: HBC.US) is a wonderful company, and whether its shares are trading at a fair price.

A wonderful company?

Buffett has said in the past: “The banking business is no favorite of ours”. However, there’s one bank he believes is a wonderful company: Wells Fargo. Buffett has not only held shares in the bank since 1989, but also has been buying more during the last couple of years. Indeed, Buffet’s investment company, Berkshire Hathaway, reported a ninth consecutive quarter of purchases when revealing trading activity for Q2 this year.

One of the reasons Buffett dislikes the banking business in general is because the inherent leverage of banks “magnifies the effects of managerial strengths and weaknesses”. In Wells Fargo, Buffett has strong, passionate and committed managers. Chief executive John Stumpf has been with the bank since 1982, and many senior personnel have shown similar dedication to their company.

HSBC’s chief executive, Stuart Gulliver, just trumps Stumpf on length of career, having started with HSBC in 1980. Since his appointment to the top post during 2011, Gulliver has spent much time apologising for HSBC’s failings of the Noughties and working to get the bank back to its principles of the 1990s under Sir William Purves. Gulliver has said of Purves:

“He had a combination of a hard-nosed mathematical approach to stuff, together with a high set of personal values, which he expected from all of his top team. And we basically stuck to doing a few reasonably simple things very well”.

Gulliver’s words actually capture the essence of what makes Wells Fargo a wonderful company in Buffett’s eyes.

In banking, hard-nosed mathematics and doing a few reasonably simple things very well boil down to borrowing money at a low rate, lending it at a higher rate and minimising losses on bad loans.

Borrowing money at a low rate (a low ‘cost of funds’) is the foundation. Wells Fargo is the US’s lowest-cost operator; cost of funds is currently running below 1%. Buffett prizes this competitive advantage highly.

The table below shows HSBC’s cost of funds, half-year by half-year over Gulliver’s tenure to date.

  31/12/2011 30/062012 31/12/2012 30/06/2013
Cost of funds (%) 1.56 1.45 1.27 1.15

Gulliver’s passion for HSBC, his long commitment to the company, and the direction in which he’s now taking it, are stamping the bank with Buffett wonderful-company hallmarks.

A fair price?

Back in the golden years of the 1990s to which Gulliver refers, HSBC traded at three times book value. We may never see that lofty valuation again, but if Gulliver succeeds in what he’s set out to do, HSBC will surely be worth more than the 1.2 times book value it’s currently trading at. Incidentally, Buffett has been happy to pay 1.5 times book value for Wells Fargo.

Buffet's big UK bet

Buffett rarely invests outside his home US market, but has backed one well-known UK business big-time. The multi-billionaire owns over 5% of this company's shares.

If you'd like to learn all about Buffett's big UK bet, you may wish to read this exclusive in-depth report. The report is 100% free and can be in your inbox in seconds -- simply click here.

> G A Chester does not own any shares mentioned in this article.