After the start of the banking crisis in March, many wondered if Warren Buffett's Berkshire Hathaway (BRK.A -0.30%) (BRK.B -0.26%) would take advantage of the sell-off in the sector and buy bank stocks.
While Berkshire didn't do too much buying in March and actually sold some of its longtime bank holdings, the company did load up on credit card company Capital One Financial (COF -1.95%). Berkshire purchased more than 9.92 million shares, which are currently valued at more than $903 million. With Berkshire buying Capital One stock, should you? Let's take a look.
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It's all about credit
Over the last year, investors have sold Capital One, largely as they brace for a recession and worry about higher loan losses. While the banking crisis raised concerns about liquidity, with 78% of Capital One's deposits insured by the Federal Deposit Insurance Corp. (FDIC) and with the company having mostly a consumer deposit base, I don't really have concerns about liquidity at the company, although I expect deposit costs will continue to rise this year.
The big concern is really whether or not the company can effectively manage credit through a recession, which could end up being severe. During the first quarter, the credit card net charge-off rate, which looks at debt unlikely to be collected as a percentage of total credit card loans and is a good indicator of loan losses, rose from 3.27% to 4.06%. Capital One also built its total reserves for loan losses by about $1.1 billion in the quarter.
Capital One CEO Richard Fairbank said on the company's earnings call that management believes the monthly charge-off rate will reach pre-pandemic levels by the middle of this year. Fairbank did not try to spin things either, suggesting that the reserve ratio could grow from here and that credit could continue to deteriorate.
"We've tended to see that periods of abnormally good credit are followed by periods of worse credit and vice versa. And the credit performance we saw over the past three years was unprecedented," he said, referring to how benign it's been.
Given the unprecedented rate of inflation, Fairbank expects to see real incomes compress, which may impact credit quality separately from just unemployment moving higher, although Fairbank acknowledged that this kind of inflation hasn't been seen in about four decades so it's hard to model.
But Fairbank also noted that historically credit losses more or less mimicked the unemployment rate and that Capital One's credit metrics tend to move a quarter or two ahead of the industry. Additionally, the growth of 30-plus day delinquencies in the credit card portfolio did slow in Q1. After rising 45 basis points (1 basis point = 0.01%) in the fourth quarter of 2022, 30-plus day delinquencies rose 22 basis points in Q1.
Capital One also currently has enough reserves to cover losses on 7.59% of its credit card portfolio, building in a pretty big buffer from where the net charge-off rate is now.
Should you follow Buffett?
Obviously, no one knows exactly what is going to happen with the economy, which makes buying a consumer finance company scary right now, especially because Capital One does lend to a lot of subprime borrowers. But I certainly think if unemployment rises to 5%, Capital One is well prepared to deal with the losses. The company also has a strong capital position, which should allow it to manage through some unforeseen events, albeit not without taking a hit to earnings.
I also think Buffett and the team at Berkshire are likely fans of Capital One's management team, which has been in the credit card business for decades and which successfully navigated through multiple recessions.
There is always going to be a risk in investing in consumer credit on the eve of a potential recession, but Capital One now trades at just 87% of its tangible book value or net worth, which bank stocks trade relative to, so a lot of the concerns are likely priced in, presenting a good time to jump in and invest alongside Buffett.
