The Best Place to Find Great Bank Stocks

Berkshire Hathaway's portfolio will lead patient, long-term bank investors to riches. Image source: iStock/Thinkstock.

If you're looking for a good bank stock to buy, the best place to begin (and end) your search is Berkshire Hathaway's (BRK.A -0.13%) (BRK.B -0.27%) portfolio, a third of which is comprised of bank stocks. Under chairman and CEO Warren Buffett, the Omaha-based conglomerate has invested heavily in a wide range of banks, from Wells Fargo (WFC -1.03%) to Goldman Sachs (GS -0.91%) to the Bank of New York Mellon (BK -0.37%).

*As of Feb. 23, 2016. **Berkshire's position in Bank of America consists of $5 billion worth of preferred stock and warrants to purchase 700 million shares of common stock for $7.14 per share. Data source: CNBC's Berkshire Hathaway Portfolio Tracker.

While these companies run the spectrum of bank business models, the one thing that most of them share is a durable competitive advantage, or moat -- I say "most" because one could argue that Bank of America's competitive disadvantages outweigh its advantages. "In business, I look for economic castles protected by unbreachable moats," Buffett once said.

Bank moats come in two forms, as Buffett explained in his 1987 letter to Berkshire Hathaway shareholders:

The insurance industry [which is identical to the bank industry for present purposes] is cursed with a set of dismal economic characteristics that make for a poor long-term outlook: hundreds of competitors, ease of entry, and a product that cannot be differentiated in any meaningful way. In such a commodity-like business, only a very low-cost operator or someone operating in a protected, and usually small, niche can sustain high profitability levels.

This approach comes through loud and clear when you examine Berkshire's bank stocks. A cursory look at Wells Fargo, Goldman Sachs, and the Bank of New York Mellon bears this out:

• Wells Fargo is one of the most efficient banks in the country. Its efficiency ratio last year was 57.8%, which is well below the 60%-plus range of a typical bank. Not only does this allow Wells Fargo to earn more money than most of its peers, it also gives the San Francisco-based bank the flexibility to underprice competitors in its efforts to gain market share.
• While most people wouldn't think of Goldman Sachs as a niche company, it's one of only two stand-alone capital-rich investment banks to have survived the financial crisis -- though, to be clear, it's formally a bank holding company. And compared to its counterpart, Morgan Stanley, there's little doubt that Goldman Sachs is the best of the (small) bunch when it comes to trading, advising on mergers and acquisitions, or underwriting debt and equity securities.
• The Bank of New York Mellon is a true niche company – it's also, in my opinion, the most interesting bank in America. It's one of only two large custodial banks in the country, the other being State Street. These banks provide critical infrastructure for the fixed-income markets by serving as the custodians over roughly $60 trillion worth of securities. The other big banks can't encroach on the Bank of New York Mellon's territory because they need it to administer the securities that they create. And smaller banks can't get into the business because the entry barriers are prohibitive. The Bank of New York Mellon and State Street have built up trust over hundreds of years; that's not something that can be easily replicated.

In short, although I only went through three of Berkshire Hathaway's bank stock holdings, I trust you get the point. The objective is to locate and then invest in banks that have one of two durable competitive advantages: either cost- or niche-based. And to do so, one needn't look any further than Berkshire Hathaway's portfolio. For investors, it truly is the best place to begin and end your search for great bank stocks.