Buffett isn't a fan of diversification. In his early days, he had more than half of his entire portfolio in a single stock: Geico.
Today, nearly half Berkshire Hathaway's (NYSE:BRK-A)(NYSE:BRK-B) wealth is invested in just one industry: finance. Yes, the big, bad banks like Bank of America (NYSE:BAC), or Goldman Sachs (NYSE:GS). Companies that most investors doesn't want to touch.
What's Buffett see in banks and insurance that others don't see?
Banking's big advantage
When we think about banks, we're likely to think about big lawsuits against Bank of America, big fees, or protests outside Goldman Sachs' world headquarters. But from the perspective of investors, it doesn't get much better than bank stocks. Why else would Berkshire Hathaway be stuffed to the brim with banks?
Buffett understands that not all earnings are created equal. In fact, in many industries, earnings are fictitious. There's a big disconnect between what a company earns in net income, and how much wealth it has created for shareholders.
Look at railroads. In the past year, CSX (NASDAQ:CSX) earned $1.9 billion in net income, but only $943 million of that was cash. Most of those earnings were just accrual earnings. CSX has to put a boatload of its profits back into replacing aging rails, repairing rail yards, etc. Many industries suffer from this cold accounting truth: Their earnings aren't as they appear.
Banks produce cash earnings
Unlike virtually every other industry under the sun, when banks and insurance companies make money, it's in the form of cash. If not, it's in the form of an asset that can be sold quickly for cash. It's just a function of the business model.
Banks and insurance companies make investments with cash, and they can liquidate those investments, at any time, for cash at a price very close to their value on the balance sheet.
So when an insurer or a big bad bank reports $1 billion in bottom line income, you can bet that those earnings are real. Those earnings are money that can be paid out to shareholders, or income that can be reinvested into making new loans.
Goldman Sachs had a $938 billion balance sheet at the end of 2012. Just $8.2 billion of that amount was premises and equipment. Bank of America had a $2.2 trillion balance sheet, of which only $11.8 billion is attributed to premises and equipment. You get the point: A bank's "capital expenditures" are primarily investments in stuff it can liquidate at its value -- stuff that doesn't depreciate or need replacing 10 years down the road.
A new way to think about banks
When Bank of America writes $100 million in loans and earns 5% on its investment the next year, it has $5 million in pure cash profits. When CSX lays $100 million in railroads and earns $6 million the next year, much of it has to be spent just to ensure the money comes again the year after.
That's the big difference. A bank's bottom-line net income is basically what we'd call "free cash flow" at most other, asset-heavy businesses.
Banks don't have to remodel their corner branch to drive profits. They don't need to make loans if they don't want to grow their balance sheet. And when they don't want to grow their balance sheet, they can distribute their earnings to shareholders with repurchases and dividends.
Buffett understands this. He understands that when banks trade at book value and generate 10% returns on equity, the 10% of the value of his shares could theoretically be paid back to Berkshire Hathaway in cash, one way or another. And, if in the event a bank would ever want to shrink, it can return capital in cash to shareholders by selling assets at their book value. That's a very comfortable place to be.