Warren Buffett and the large conglomerate he runs, Berkshire Hathaway (BRK.A -0.67%) (BRK.B -0.70%), have a history of investing in bank stocks. Over the last two decades, Berkshire had at one point or another invested in virtually every major Wall Street bank. Every bank, that is, aside from Citigroup (C 0.37%).

It makes sense. Citigroup was a mess after having too much subprime exposure during the Great Recession, and its returns greatly lagged peers ever since. In 2020, the bank landed in regulatory trouble, and the stock now trades at a big discount.

Then, in the first quarter of 2022, things changed and Berkshire purchased a sizable position (currently valued at around $2.4 billion) in Citigroup. After Berkshire sold shares of other key holdings in the third quarter, the embattled Citigroup finds itself in a top-20 position in the conglomerate's portfolio and Berkshire's third-largest bank holding. 

Why Citigroup was a mess 

Since the Great Recession, Citigroup's financial returns consistently lagged in a sector that really had to work hard to regain its reputation. That's because large banks were at the center of the housing market debacle in 2007-2009.

WFC Return on Equity Chart

WFC return on equity, data by YCharts.

Since 2008, Citigroup's return on equity has fairly consistently trailed behind the peer group. The situation worsened in 2020 when regulators hit the large bank with a $400 million fine and a consent order telling it to fix long-standing issues with its internal controls and risk management.

Then at an investor day earlier this year, management said that its midterm financial target for return on tangible common equity would be 11% to 12%, which is an improvement to be sure, but once again below peers' mid- and long-term targets. The stock currently trades at just 55% of its tangible book value (or net worth).

A potential turnaround

Following the regulatory orders, Citigroup promoted Jane Fraser as the new CEO, and she formally began her stint at the beginning of 2021. Fraser didn't waste time, quickly announcing that the bank would be winding down its international consumer banking operations.

Citigroup operates a sprawling global franchise that makes it difficult to analyze because it is affected by global interest rates and national economies more than other banks. It also doesn't have the same kind of U.S. presence as its peers.

But investors seemed to like the decision to exit a lot of these international consumer markets. It would make the bank simpler and allow management to focus on stronger parts of its business such as corporate and investment banking and wealth management, which are more capital-efficient and have the potential to generate stronger returns.

The divestitures of these international consumer units will free up capital that Citigroup can use to invest back into the business and eventually repurchase stock while it trades at a discount.

But expenses at the bank are still running high and the transformation looks like one that will take several years to play at. Some investors are done waiting, while others question whether or not management can really execute.

Buffett likes his odds

Citigroup has all the makings of a classic Buffett investment. It trades at a beaten-down valuation, it has a turnaround plan that the Oracle of Omaha seems to be on board with, and Berkshire can collect a healthy annual dividend with a nearly 4.6% yield while it waits for the transformation to take place.

Now, while it's true that Citigroup's midterm financial targets are nothing to cheer about, they look a lot better when you look at the bank's discounted valuation. Given that Berkshire maintained its healthy stake in Citigroup after cutting other key bank holdings such as U.S. Bancorp and Bank of New York Mellon in the third quarter, it would seem that Buffett agrees.