Why Warren Buffett Likes but Giving Up Some Banks

(Various) Over the past decade, banks have started to play an increasing part in the portfolio of Warren Buffett at Berkshire Hathaway.

Some analysts have reacted with surprise at this. Buffett's circle of competence has always been insurance and fast-moving consumer goods.

However, from my view, banks do seem to fit the template of the sorts of companies Buffett has always liked. What's more, these businesses are relatively easy to understand.

The banking model

The basic bank business model is relatively simple to explain and understand. Depositors entrust their money to the bank at a specific rate of interest. The bank then loans this money out at a rate it believes provides a suitable profit. For example, if the bank paid 0.3% interest on checking accounts, it could loan the money out at a 2% interest rate.

There are some other factors to consider, such as asset and liability matching and duration matching. Still, at its core, the business of banking is all about lending money out at a higher rate than what is paid to depositors.

Using this business model, banks can generate huge returns on tangible capital. Buffett has always been interested in businesses that can earn substantial returns on invested capital, so it makes sense that he'd be interested in banks.

Indeed, the Oracle of Omaha said as much at the 2003 annual meeting of Berkshire's shareholders:

"The question about banking, you know, banking -- if you can just stay away from following the fads, and really making a lot of bad loans, banking has been a remarkably good business in this country.

...

And there are many -- there are certain banks, I should say -- in this country that is quite large that are earning, you know, maybe 20% on tangible equity. And when you think you're dealing in a commodity like money, that's fairly surprising to me. So, I would say that I guess I've been surprised by the degree to which margins in banking have not competed away in something as fundamental as money...

Now, part of it is that they push -- they have pushed the loan-to-capital ratios higher than 30 or 40 years ago, but that -- nevertheless they earn high rates of returns. They earn much higher rates of returns on assets alone, and then they have greater leverage of assets-to-capital so that produces returns on capital that really are pretty extraordinary."

These comments help explain the core reasons behind Buffett's interest in bank stocks. In 2003, he also warned of the risks of bad behavior at banks, specifically lenders taking on too many bad loans or too much leverage.

Bank investors will always be exposed to these sorts of risks. As the size of financial institutions has increased, it has become harder and harder for investors to establish how they are generating profits and if there are any weak areas on the balance sheet.

Nevertheless, large banking institutions are relatively protected from bad loans through diversification. They are also significantly better capitalized today than they were before the financial crisis. Regulations have been tightened as part of policymakers' efforts to tidy up the sector.

Low-interest rates in recent years have caused problems for financial institutions, but as Buffett explained in 2003, even with interest rates at low levels, banks can still earn attractive returns on tangible capital. Leverage plays a part, and so do economies of scale. The world will always need banks, and our dependence on these financial institutions is only increasing as cash is phased out.

Companies with high returns on tangible capital and attractive long-term prospects are just the sort of businesses that the Oracle of Omaha wants to own.

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