There's little denying that Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) CEO Warren Buffett is one of the greatest investment minds of our time. Buffett has managed to grow his net worth to $90 billion from just $10,000 in seed capital in the mid-1950s, all while creating more than $400 billion in value for Berkshire's shareholders. Not too shabby.

Maybe more interesting is the fact that Buffett isn't doing anything particularly special when it comes to the stock-picking process. There aren't any fancy software programs at work here. Rather, Buffett and his team buy brand-name companies with sustainable competitive advantages and hang onto these investments for a long period of time, thereby allowing compounding to do its work.

Berkshire Hathaway CEO Warren Buffett at his company's annual shareholder meeting.

Berkshire Hathaway CEO Warren Buffett at his company's annual shareholder meeting. Image source: The Motley Fool.

Buffett has an affinity for money-center banks

For his part, Buffett has never been much of a fan of diversification, as long as you know what you're doing. At last check, financials made up more than 45% of Berkshire Hathaway's portfolio, with the Oracle of Omaha having a particular affinity for money-center banks. Of Berkshire's 12 largest holdings, 8 are banks or financial-service companies.

Why banks? The simple answer is that Buffett believes they're moneymaking machines. Banks are highly cyclical, meaning they tend to do very well when the economy is expanding and struggle to grow their bread-and-butter deposit and loan metrics during periods of economic contraction or recession. Since the U.S. economy spends way more time expanding than contracting, big banks have become a cornerstone of long-term profitability and outperformance.

Financial services also have some of the highest total yields (i.e., dividend payouts plus share buybacks) of all sectors. Though banks have to get the go-ahead from the Federal Reserve on their capital return plans, we've witnessed some truly mammoth shareholder return announcements recently. For instance, Bank of America (NYSE:BAC) announced plans in mid-2019 to return a little more than $37 billion to shareholders through dividends and buybacks over a one-year time frame, which was a 42% increase from the $26 billion in payout and repurchases approved in mid-2018. Bank of America is Buffett's second-largest holding in terms of market value.

Operating consistency and income are a pretty solid combination to win Buffett over. But in the first week of earnings season, things didn't go as planned.

A small pile of one-hundred-dollar bills on fire, with one-hundred-dollar bills also being used as wallpaper in the background.

Image source: Getty Images.

Banks cost the Oracle of Omaha big-time last week

Last week, seven of Buffett's bank holdings wound up reporting their fourth-quarter operating results. Only two ended the week higher, despite the broad-based S&P 500 gaining 2% over the same period. Here are how Buffett's big banks fared last week (parentheses denotes a loss in market value for Berkshire Hathaway):

  • Wells Fargo (NYSE:WFC): ($1,256,185,140)
  • Bank of NY Mellon (NYSE:BK): ($352,886,410)
  • U.S. Bancorp: ($174,846,696)
  • PNC Financial Services: ($34,944,348)
  • Bank of America: ($28,432,800)
  • JPMorgan Chase: $126,766,805
  • Goldman Sachs: $134,899,217

Added up, these seven banks cost Berkshire Hathaway a cool $1.59 billion last week. Mind you, this includes a dividend payment to shareholders from PNC Financial midweek.

The real story this earnings season, at least through week one, is that lower interest rates are bad news for big banks. Following nine 25-basis-point rate hikes from the Federal Reserve between December 2015 and December 2018, the nation's central bank wound up cutting rates by 25 basis points on three separate occasions in 2019. It often takes a good year before any rate changes begin to have an impact on the economy, but we're already witnessing the negative impact of these cuts on bank operating results.

For instance, Bank of NY Mellon, the largest custodial bank in the world, saw its interest revenue fall by 8% to $815 million during the fourth quarter, driven lower by declining interest rates. BNY Mellon has been investing in technology to help automate a number of its processes, which in the long run should reduce its noninterest expenses. But at the moment, these investments, coupled with other cost-cutting, aren't coming close to offsetting the negatives associated with lower interest rates.

It was a similar story for Wells Fargo, which saw its profit more than halved in the fourth quarter from the prior-year period. Wells Fargo's case is a bit unique in that it also had its operating results adversely impacted by $1.5 billion in litigation expenses tied to its fraudulent-account-creation scandal from 2016. Nevertheless, Wells Fargo's net interest margin fell by 41 basis points to 2.53% from Q4 2018, with the yield on its total earning assets declining 42 basis points to 3.51% from the prior-year period.

The facade of the Federal Reserve building.

Image source: Getty Images.

Money-center banks are long-term winners, but things could get worse before they get better

It is worth noting, though, that these traditional banking giants still delivered gains in their bread-and-butter departments, with Bank of America, Wells Fargo, JPMorgan Chase, and U.S. Bancorp all reporting year-over-year improvements in their total loans and deposits.

Although he got burned by his big banks last week, Buffett's unlikely to make any hasty decisions to pare down his holdings following their respective earnings reports. That's because, as noted, banks tend to outperform for long periods of time. The U.S. economy rarely spends a lot of time in recession, which makes the financial sector a good bet to create wealth for investors.

However, 2020 could very well prove to be a challenging year for bank bottom lines. The full effect of the Fed's three rate cuts will soon be felt in terms of interest income generation, and the U.S. economy is arguably in the late stages of the longest economic expansion in history. That might mean an underperforming year for big banks but also an opportunity to, at some point in the not-so-distant future, pick up financial-services companies at attractive valuations for the long term.