In 1990, Warren Buffett (Trades, Portfolio) wrote in a letter to Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial) shareholders:
“The banking business is no favorite of ours. When assets are 20 times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the 'institutional imperative:' the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.”
After such a statement, it would be easy to believe that Buffett has no interest in investing in banks. However, Berkshire Hathaway has invested in financial companies. They simply invest in “well-managed banks at fair prices.” So, how does he analyze financial companies, given their complexity?
The balance sheet complexity
Buffett notes that financial companies like banks and insurers have enormously complex balance sheets with many moving parts. This makes it harder to analyze them. For example, insurance firms have massive reserves that significantly impact earnings. However, estimating appropriate reserve levels is highly subjective, even for companies Berkshire Hathaway owns.
With reserves in the tens of billions, small percentage differences dramatically swing profits. Similarly, major banks like Wells Fargo & Co. (WFC, Financial) have hundreds of billions in trading assets and investment securities. Small changes in valuation assumptions on these assets can wildly affect earnings. The sheer size and intricacy of financial balance sheets create uncertainty in identifying core earnings. Minor subjective tweaks by management can greatly alter the bottom line from quarter to quarter. This balance sheet complexity makes financials harder to analyze.
Estimating loan losses
Banks like Bank of America Corp. (BAC, Financial) provide limited transparency in their loan portfolios. This makes assessing creditworthiness across the entire book difficult. Moreover, loan losses are highly cyclical. In recessions, defaults spike as businesses and consumers struggle. But even veteran bankers struggle to predict the magnitude and timing of these credit downturns.
For instance, net charge-off rates rapidly quintupled from 1% to 5% in 2008-09. These sudden surges in loan losses that accompany crises, along with opaque portfolios, make bank earnings highly volatile and tough to forecast. The combination of poor loan transparency and economic cyclicality poses challenges in analyzing banks.
The unknowns of trading
Major banks like JPMorgan Chase & Co. (JPM, Financial) have vast trading operations spanning assets like securities, derivatives, currencies and commodities. These introduce uncertainties and volatility into the analysis. Speculative trading produces large but unpredictable gains and losses tied to market movements. JPMorgan Chase lost billions on errant derivatives trades. Wells Fargo took a $4 billion trading hit when Covid-19 struck. Mark-to-market fluctuations on huge investment portfolios also swing earnings.
This trading risk and complexity compounds challenges in analyzing financial conglomerates. The opaque nature of trading books means outside investors may not fully grasp embedded leverage and derivatives risks. Overall, major trading activities make bank earnings erratic and harder to predict.
Flexibility in accounting rules
Banks and insurers operate under specialized accounting rules, allowing significant discretion compared to other sectors. Management can tap this flexibility to flatter results. For example, they have latitude in critical areas like reserving, asset valuation, credit loss recognition and derivatives modeling. Assumptions in these areas involve subjectivity.
Banks like Bank of America in recessions sometimes get leeway to delay loss recognition. This accounting malleability allows managers to mask problems in the short term and “dress up” the books. Thus, reported results should be viewed skeptically.
Focus on long-term earnings power
To cut through the complexity and flexibility in bank accounting, Buffett focuses on long-term earning power rather than fixating on quarterly numbers. He aggregates several years of results to filter out volatility and discern core trends. Buffett explains that rather than get distracted by short-term gyrations, he examines banks like he would any other business – by looking at normalized earnings over a full economic cycle.
This long-term perspective reveals the fundamental economics much better than quarterly figures that swing around. By smoothing out trading gains andlosses, reserve changes and other noise, you get a clearer picture of how the bank performs through different environments. The granular quarterly numbers may confuse more than enlighten due to the particular complexities of financial institutions.
Valuation based on cash flows
In addition to focusing on long-term earning power, Buffett values financial companies based on discounted cash flows like any other business. This means projecting future cash generation for a bank or insurer based on factors like growth prospects and margins. The emphasis is on free cash flow available to shareholders – not accounting net income.
This approach has a number of advantages. First, it minimizes distortions from management’s flexibility in reporting accounting earnings. Cash flow is harder to manipulate. Second, concerns about risk can be incorporated via the discount rate applied rather than directly adjusting earnings. Overall, cash flow-based valuation relies less on the changeable accounting numbers. This provides a more solid grounding for determining intrinsic value.
Seeking conservative banking cultures
Since loan losses are difficult to predict for banks, Buffett seeks institutions with credit cultures focused on prudent, consistent underwriting. Steady standards help loans remain profitable through various business environments. As Buffett notes, banks who stick to “sound banking methods” are far more durable than those chasing trends and relaxing standards to gain market share.
Conservative loan and securities portfolios are key indicators of discipline that reduce risk. For example, Wells Fargo’s losses during the financial crisis were lower due to their risk aversion. Buffett wants banks to focus on bread-and-butter lending based on the local knowledge of borrowers rather than trendy businesses they do not fully comprehend. A conservative culture makes banks more predictable investments.
Investing at a discount to book value
Given the many difficulties analyzing opaque financial companies, Buffett insists on a substantial discount to intrinsic value or book value before investing. He recognizes that standard metrics like price-earnings ratios or price-book ratios likely overstate the “true” value of banks and insurers. Thus, demanding an adequate margin of safety in terms of price is critical.
During the financial crisis, Buffett invested in Bank of America and The Goldman Sachs Group Inc. (GS, Financial) at distressed valuations when others were fearful. This skepticism and contrarianism protect the downside if problems emerge. Many bank stocks still appear cheap based on price-to-book. But it is wise to tread carefully given uncertainties hidden beneath the surface. Demanding a bargain acts as an insurance policy.
Staying objective and contrarian
Ultimately, Buffett stresses remaining rational and objective when analyzing financial companies. Fear and greed tend to overshoot, causing bank stocks to swing wildly. The sector depends heavily on public trust and confidence. But the crowd frequently becomes either too exuberant or too pessimistic.
Buffett tries to shut out the noise and stick to the facts. He describes doing your own work and having the discipline to think independently as key to success. Avoid just mimicking the crowd since following the herd often ends badly in banking. Instead, stay rational when others lose their heads. Be fearful when they are greedy, and vice versa.
Why navigating the financial maze is worth the effort
In the end, Buffett acknowledges that analyzing financial companies is far from simple. Opaque balance sheets, unknowable risks, flexible accounting rules and fickle market sentiment all conspire to obscure the core economics.
Yet despite these challenges, the patient and disciplined investor, who adheres to sound principles with an independent, long-term mindset, can find value. As Buffett exemplifies, maintaining rationality when others devolve into emotion opens the door to strong results. Financials may seem impenetrable to most, but they offer rich rewards to those with the fortitude to see through the fog.
For over half a century, Buffett has seized opportunities in complex financial companies that leave most investors confounded and dismayed. By focusing on fundamentals and ignoring the noise, his trademark patience and discipline will continue uncovering hidden gems in the financial space.
