Friday, August 8, 2014

Why Warren Buffett likes Investing in Bank Stocks

Warren Buffett is the second richest person in the world, a self-made billionaire investor that has a very large following. He is well known for turning struggling textile manufacturer Berkshire Hathaway (BRK.B) into a 300 billion dollar conglomerate, through investing in sound companies like Coca-Cola (KO), American Express (AXP), Geico etc. One of his largest holdings is the bank Wells Fargo (WFC). Warren Buffett has been holding on to Wells Fargo for a little under 2 decades. When I first analyzed the company in 2013, I was not overly impressed. I was more impressed with the big five Canadian Banks. However, as I did some thinking and pondering, I realized my original thesis might have missed out on a lot of other concepts, which is why I initiated a small position in the bank a few months later.

Buffett has claimed that investing in Berkshire Hathaway was a big mistake, because the business was destined for poor profits and required constantly new capital in order to keep up and stay competitive. He has mentioned that had he purchased insurance companies outright, he would have been much richer today. His knowledge of insurance business had started accumulating in the 1950s, after purchasing GEICO, and Western Insurance Company that was selling at less 1 times earnings. Back in the late 1960s, Buffett acquired the National Indemnity company through Berkshire Hathaway. He has been investing in insurance companies for the next five decades.

The reason why he liked insurance companies is due to their float. Per Warren Buffett's words, "Insurers receive premiums upfront and pay claims later. ... This collect-now, pay-later model leaves us holding large sums — money we call "float" — that will eventually go to others. Meanwhile, we get to invest this float for Berkshire's benefit. ..."

Insurance companies usually use proceeds acquired through float, and invest it in safe instruments like government or corporate bonds. If an insurance company ends up paying out less in claims than the premiums it receives, it turns an underwriting profit. In other words, it used those premiums paid by policyholders and earned interest income on it, while also earning a profit on the insurance process. In other words, the premium amounts from policy holders serve as a sort of margin loan, which does not cost anything to the insurance company that at least manages to break even. If that insurance company can at least maintain a break-even point on insurance proceeds, and can at least maintain a stable level of premium amounts, it can end up in a pretty nice position for itself. It is a really nice situation to be when you get almost free cost of capital, that you can then deploy at higher rates of return.

Most other insurance companies tend to keep selling insurance, even if they are no longer compensated well for the risk. Berkshire Hathaway however only does this when they expect to at least earn some money on the policies. This is because if you take on a future potential liability, without being properly compensated, you will lose money. In an industry, where you receive money today in order to pay for claims at an unknown time in the future, taking unprofitable business could have devastating effects on shareholder equity in the business. This is where the concept of having able and honest management comes into play.

As I was looking over the annual reports of Wells Fargo, I realized the reason why Buffett really likes the bank so much. It essentially receives cash from depositors, who are not really getting paid that much. In effect then those banks use those almost free capital to make loans to creditworthy borrowers, and profit from the spread, minus their operating costs.

Of course in either bank or insurance operations, you don’t want management that takes reckless risks,

The other factors that help in Buffett’s investments in Wells Fargo (WFC) and Bank of America (BAC) is the nature of customer relationships. If you bank with your Wells Fargo, you are more likely to consider them when you need a loan for a new car, house, or to start a business. In addition, you are exposed to their cross-selling of investment services, credit card services etc.

Results from insurance operations can be lumpy, and so are earnings from bank operations. Financial crises do happen, which results in dividend cuts in many institutions every so often. However, for the long-term patient accumulator of capital, the holding period of forever should work to their advantage.

Unfortunately, Berkshire Hathaway cannot acquire a bank outright, due to current US regulations. Hence, its ownership in the bank is limited to having a partial ownership interest in financial institutions. However, the lessons should provide an interesting model for investors to have in their minds, as they analyze banks for potential inclusions in their income portfolios.

As I discussed in my previous article on Monday, I recently added to my position in Wells Fargo. In addition, in the past month I also sold some long-dates puts on the bank. I expect to ultimately build this position out slowly over time. I believe that banks like Wells Fargo will continue being a good investment for patient long-term shareholders with a 30 year time horizon. Things could get lumpy, especially during the next crisis. However, I think that banks with prudent management that manage to provide loans to creditworthy borrowers and also manage to earn recurring revenues through their business relationships with clients, will do well over time. After all, while there is obsolescence in many industries, I really doubt that the world would ever work without banks. Therefore, banks like Wells Fargo are the lifeblood of the economy and will keep originating loans, taking deposits and build customer relationships for decades to come.

Relevant Articles:

Warren Buffett Investing Resource Page
How to earn $900 in dividend income per minute
Should you invest in Wells Fargo (WFC)?
Dividend Stocks make great acquisitions
Business Relationships Can Deliver Solid Dividends to Shareholders

10 comments:

  1. Warren Buffett owns many dividend growth stocks. I think that is what he likes most of all, increasing income streams, which fuel further purchases.

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  2. Let's not forget insurance company Munich Re. Great Buffet stock with very attractive p/e and nice yield.

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  3. I am glad you point out that much of Buffett's success comes from the shrewd use of leverage (in the form of float). In fact, for many years that was one metric he always measured in his annual letter; what the cost of capital was always comparing it to long term debt. Some years he was actually paid to take float and invest it. Too many believe he chose good stocks and earned outsized returns. Buffett himself says that most people should simply own index funds, and that most people includes professional investors. I think it is a mistake to selectively take the Oracle's advice. People are kidding themselves if they believe they can duplicate Buffett's performance by purchasing a basket of dividend paying stocks at reasonable valuations. That said, there are much worse things people can do.

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  4. Banks are still affordable right now. I might go in at $45 if the legal losses in the news don't drain to much.

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  5. I bought some between $35-$40, I wish I could have afforded more WFC at the time.

    Looking forward to any major correction this fall, bring it on.

    Mark

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  6. One more reason why Warren Buffet like these companies is because these are perpetual businesses that run little risk of collapse.

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  7. Nice breakdown of one of the few gems in the banking industry. Before the recent financial crisis it was hard for me to imagine some of these giants not surviving for decades to come. I have been keen on making NYCB the first bank I add to my portfolio - 6% yield and one of the few major banks that turned down TARP money.

    First comment here but a looong time reader and fan of your site =)

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  8. "After all, while there is obsolescence in many industries, I really doubt that the world would ever work without banks."

    -- This is so true.

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  9. I have a question about Buffett's original partnerships. Were the dividends of companies held counted towards profits, and were they paid out to the partners?

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