Warren Buffett: Why You Must Own Bank Stocks

Summary

In this insightful discussion, the speaker evaluates the banking industry's profitability, emphasizing that banks can yield high returns on tangible equity if managed prudently. They compare bank stocks' historical price-to-earnings multiples to the S&P 500, noting a significant decline. The speaker advocates for a nuanced approach to valuing banks, considering their potential to generate cash flows over time rather than relying on a single metric like PE ratios. They also reflect on their own underestimation of the banking sector's performance, acknowledging that many banks have achieved impressive returns on equity despite the challenges of operating in a commodity-like industry.

Takeaways

• 🏦 The banking industry has historically earned high returns on tangible equity, which is a significant advantage over other industries.
• 📈 Banks that Warren Buffett and his partner Charlie Munger own have earned between 12% and 16% on tangible assets, indicating a robust business model.
• 💹 The long-term bond yield at 2% makes banking with a 12% return on assets a winning investment strategy over time.
• 📊 Bank stocks have been trading at a significant discount to the S&P 500, potentially due to market perception of risk or growth prospects.
• 🔍 The relative PE multiples of bank stocks have declined over the decades, suggesting a change in market valuation methods or expectations.
• 🏛️ Not all banks are created equal; some have consistently earned low-risk returns on assets, while others have failed due to poor management.
• 🤔 Buffett acknowledges that he and Munger have underestimated the banking industry's ability to generate high returns on equity.
• 💼 The banking sector's success is not homogeneous, and it's crucial to evaluate each bank's management, risk profile, and growth potential individually.
• 💵 The key to successful investing in banks or any business is to understand the cash it will generate over time and buy it at a discount to that value.
• 🚫 Buffett warns against relying on a single metric like relative PE to make investment decisions; a more comprehensive analysis is necessary.

Q & A

What is the speaker's view on the profitability of the banking industry?

The speaker views the banking industry as highly profitable, particularly when banks avoid making poor decisions on the asset side. They mention that banks can earn between 12% and 16% on tangible assets, which is a good business, especially when compared to long-term bonds at 2%.

How does the speaker compare the returns on equity of banks to other businesses?

The speaker suggests that banks can achieve returns on equity that are well beyond what more glamorous businesses have earned in recent years. They imply that this is due to the nature of banking, which allows for high leverage and thus high returns on equity.

What is the speaker's opinion on the current valuation of bank stocks relative to the S&P 500?

The speaker notes that bank stocks are currently trading at a significant discount to the S&P 500, possibly due to market perceptions of forward growth rates or risk. However, they also suggest that this could be an opportunity, as they believe banks are fundamentally strong businesses.

Why does the speaker believe that banks have been able to achieve high returns on equity despite dealing in a commodity like money?

The speaker acknowledges that banks have been able to achieve high returns on equity by stretching equity further than was considered prudent in the past. They also suggest that banks have been able to employ more capital at the same high rate of return, which has contributed to their high profitability.

What does the speaker think about the use of a single metric, such as relative PE, to determine investment decisions?

The speaker discourages relying on a single metric like relative PE to make investment decisions. Instead, they advocate for a more holistic approach that considers the business's ability to generate cash over the long term and the price at which it can be bought relative to that cash.

How does the speaker view the diversity within the banking industry?

The speaker recognizes that banks are not a homogeneous group. They mention examples of banks that have been well-managed and have earned high returns on assets with low risk, as well as others that have been mismanaged and have failed.

What historical context does the speaker provide regarding the valuation of bank stocks?

The speaker provides historical context by mentioning that in the 1940s, 1950s, and 1960s, bank stocks commonly traded at one times the S&P multiple, whereas now they might be half that, indicating a significant change in market perception.

What is the speaker's stance on the idea of using formulas or shortcuts for investing?

The speaker is against the idea of using formulas or shortcuts for investing. They emphasize the importance of understanding the business, its economic characteristics, and the cash it can generate over time.

Why does the speaker believe that some banks have been able to earn over 20% on equity despite having a lot of goodwill?

The speaker suggests that some banks have been able to earn over 20% on equity by stretching out equity and operating with more dollars per dollar of equity than was considered prudent in the past. They also acknowledge that they underestimated the potential for banks to achieve such high returns.

What does the speaker think about the future of bank stocks and their potential as investments?

The speaker believes that bank stocks may continue to be good investments if they can maintain high returns on equity and if they can be bought at reasonable prices. They also mention that they have made mistakes in the past by underestimating the banking industry's potential.