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8 Buffett Secrets for Investing in Banks

By Matt Koppenheffer - Nov 29, 2012 at 12:36PM

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What can one of the greatest investors of our time tell us about investing in banks?

Berkshire Hathaway's ( BRK.A 0.85% )( BRK.B 1.28% ) Warren Buffett is seen by many as one of the best investors of our time. But he's also often seen as particularly insightful when it comes to investing in banks.

Certainly Berkshire shareholders should hope that the latter is the case as the company owns 8% of banking giant Wells Fargo ( WFC 2.95% ) along with $5 billion in Goldman Sachs ( GS 2.78% ), nearly $2 billion of US Bancorp ( USB 1.42% ) stock, and roughly another $1 billion between M&T Bank ( MTB 0.68% ) and Bank of New York Mellon ( BK 1.26% ). Not to mention $5 billion in preferred shares of Bank of America ( BAC 1.27% ).

So what does Warren know that makes him so prescient when it comes to banks?

1. Owning a bank can be a long-term endeavor.
The banking business is a cyclical one, but bank ownership for Buffett typically isn't. In 1969, Berkshire acquired Illinois National Bank and Trust Company and held onto it until it was forced by regulators to sell the bank in 1980. The company's ownership position in Wells Fargo goes back to 1989, while the stake in M&T Bank dates back to at least 1999.

2. Management matters.
We've seen from the financial crisis how reckless management can lead to outright disaster. When Buffett talks about the banks he's owned, he's generally taking time to praise management. Here's what he had to say in Berkshire's 1990 shareholder letter when praising Wells Fargo's management:

[The team at Wells Fargo pays] able people well, but abhor having a bigger head count than is needed... attack costs as vigorously when profits are at record levels as when they are under pressure. Finally, [they] stick with what they understand and let their abilities, not their egos, determine what they attempt.

3. Leverage kills.
Again from the 1990 shareholder letter:

When assets are twenty times equity-a common ratio in this industry-mistakes that involve only a small portion of assets can destroy a major portion of equity. ... Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly managed bank at a "cheap" price. Instead, our only interest is in buying into well-managed banks at fair prices.

4. Panic? Not a chance.
Rather than panic during banking downturns, Buffett has used them to build his ownership stakes. The original stake in Wells Fargo was purchased between late 1989 and early 1990 -- when banks were faltering during the previous banking crisis. During the latest meltdown, Buffett upped Berkshire's ownership in Wells Fargo and US Bancorp, maintained the company's position in M&T Bank, and famously provided preferred-share financing to Goldman. Just last year he sunk $5 billion into Bank of America when it was facing a market freak-out.

The fact that Wells Fargo's price fell after Berkshire initially bought didn't phase Buffett one bit:

Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices. Investors who expect to be ongoing buyers of investments throughout their lifetimes should adopt a similar attitude toward market fluctuations; instead many illogically become euphoric when stock prices rise and unhappy when they fall. 

In case you're wondering, yes, this is that classic Buffett "be greedy when others are fearful" sentiment.

5. Know where to look for performance.
As Marty Whitman puts it: "Rarely do more than three or four variables really count. Everything else is noise." 

Three things that Buffett has highlighted when it comes to evaluating a bank are: return on assets, risk (leverage ratio), and expenses (efficiency ratio).

6. Remember to own for a long time.
There's no reason to not mention this one twice, because it's an important one. To have a year where an attractive bank he owned made no profit "would not distress us." Instead, "at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity."

7. Pick your spots to go outside the box.
With all of this in mind (especially the risk part), Goldman Sachs may not seem like a very Buffett-esque bank to invest in. And it's really not. However, when we think about the investment banks that Berkshire could have invested in -- Bear Stearns, Lehman Brothers, Morgan Stanley ( MS 3.25% ), etc. -- Goldman stands out as head and shoulders above the rest.

Not to mention that Buffett was no stranger to Goldman. In Berkshire's 2003 shareholder letter, you can find Buffett singing the praises of -- believe it or not -- a Goldman Sachs investment banker:

I should add that Byron [Trott] has now been instrumental in three Berkshire acquisitions. He understands Berkshire far better than any investment banker with whom we have talked and – it hurts me to say this – earns his fee.

8. Don't get all mushy over the whole thing.
It's certainly possible to find great banks to invest in and Buffett has found his fair share for Berkshire. But banking ain't an easy slog, and even Buffett will admit he's not going out of his way for a bank unless it's really worthwhile. As he put it: "The banking business is no favorite of ours."

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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Stocks Mentioned

Bank of America Corporation Stock Quote
Bank of America Corporation
$44.71 (1.27%) $0.56
Berkshire Hathaway Inc. Stock Quote
Berkshire Hathaway Inc.
$429,830.00 (0.85%) $3,630.00
Wells Fargo & Company Stock Quote
Wells Fargo & Company
$50.25 (2.95%) $1.44
Berkshire Hathaway Inc. Stock Quote
Berkshire Hathaway Inc.
$284.97 (1.28%) $3.59
M&T Bank Corporation Stock Quote
M&T Bank Corporation
$152.71 (0.68%) $1.03
U.S. Bancorp Stock Quote
U.S. Bancorp
$57.69 (1.42%) $0.81
The Goldman Sachs Group, Inc. Stock Quote
The Goldman Sachs Group, Inc.
$400.11 (2.78%) $10.81
Morgan Stanley Stock Quote
Morgan Stanley
$102.50 (3.25%) $3.23
The Bank of New York Mellon Corporation Stock Quote
The Bank of New York Mellon Corporation
$56.13 (1.26%) $0.70

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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