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.

Outlines

00:00

🏦 The Resilience and Profitability of Banking

The speaker begins by highlighting the rapid growth and profitability of the banking industry, emphasizing that banks have historically earned high returns on tangible equity, which is significantly higher than other industries. They mention that banks they own have earned between 12% and 16% on tangible assets, which is an impressive feat considering the low-interest rates of long-term bonds. The speaker refutes the notion that banks will decline to earning only 3-4% on tangible assets. They discuss the relative PE multiples of bank stocks compared to the S&P, noting that they are at historical lows. The speaker suggests that the market's perception of future growth rates or risk could be influencing these multiples. They also touch on the variability of bank performance, mentioning that while some banks have performed exceptionally well with low risk, others have failed due to poor management. The speaker advocates for a nuanced approach to evaluating banks rather than relying on a single metric like PE multiples.

05:01

📉 The Evolution and Opportunities in Banking

In the second paragraph, the speaker reflects on the evolution of the banking industry, noting that many banks have been mismanaged, leading to their downfall, but also creating opportunities for others. They mention the consolidation in the industry, with many banks disappearing over time, particularly in the late 80s and early 90s. The speaker advises against relying on a single metric like relative PE to make investment decisions, emphasizing the importance of understanding the business model and its ability to generate cash over the long term. They recount past experiences of evaluating and buying banks, highlighting the importance of low risk, cheap deposits, and reasonable prices. The speaker also acknowledges their own misjudgment in underestimating the banking industry's potential for high returns on equity, noting that many banks have earned over 20% on equity in recent years, which they find surprising given the commodity-like nature of money. They conclude by admitting their failure to adapt their views on banking despite these observations.

Keywords

💡Banking

Banking refers to the financial activity of accepting deposits, extending credit, and providing other financial services. In the video, the speaker discusses the profitability of banking, noting that banks have earned high returns on equity, which is a measure of a bank's profitability. The speaker also contrasts banking with other businesses, suggesting that banking can be a good business if managed prudently, as it involves leveraging other people's money to earn a return.

💡Tangible Equity

Tangible equity is the value of a company's assets minus its liabilities, excluding intangible assets. It is a measure of a bank's financial strength. The video script mentions that banks have earned returns 'well beyond tangible equity,' indicating that they have been able to generate high profits relative to their tangible assets. This is significant as it suggests that banks have been efficient in their use of capital.

💡Returns on Equity (ROE)

Returns on Equity (ROE) is a financial metric that measures the profitability of a company relative to its shareholders' equity. In the context of the video, the speaker highlights that banks they own have earned between 12 to 16 percent on tangible assets, which is a high ROE. This indicates that these banks have been able to generate substantial profits for their shareholders.

💡Asset Side

The asset side of a bank's balance sheet refers to the assets that the bank owns or controls, such as loans and investments. The speaker emphasizes the importance of managing the asset side prudently to avoid 'dumb things,' which could lead to losses. This is crucial for banks because the quality of their assets directly impacts their profitability and stability.

💡Long-term Bond

A long-term bond is a debt security with a maturity of more than ten years. In the video, the speaker compares the returns on long-term bonds, which are relatively low, to the higher returns that banks can earn on their assets. This comparison illustrates the potential for higher profitability in banking compared to other fixed-income investments.

💡Relative PE Multiples

Price-to-Earnings (PE) multiples compare a company's market value to its earnings. The speaker discusses the relative PE multiples of bank stocks versus the S&P 500, noting that they are at historical lows. This suggests that bank stocks may be undervalued compared to the broader market, based on their earnings.

💡Incremental Returns on Incremental Equity

Incremental returns on incremental equity refer to the additional earnings generated by deploying additional equity capital. The speaker uses this concept to explain how to compare the value of different businesses, suggesting that a business that can deploy capital at a high return is more valuable than one that cannot.

💡Bank Holding Company Act

The Bank Holding Company Act is a U.S. federal law that regulates the operations of bank holding companies. The speaker mentions this act in the context of how it affected their ability to buy banks in the past. This act is significant as it represents regulatory changes that can impact the banking industry and investment opportunities.

💡Risk

Risk in the context of banking refers to the potential for loss due to factors such as loan defaults or economic downturns. The speaker discusses the varying levels of risk taken by different banks, highlighting the importance of understanding a bank's risk profile when evaluating its performance and investment potential.

💡Goodwill

Goodwill in accounting is an intangible asset that represents the future economic benefits arising from assets acquired in a business combination that are not individually identified. The speaker mentions that some banks have high returns on equity despite having a lot of goodwill, which is unusual for an industry dealing with a commodity like money. This suggests that these banks have been able to generate value beyond what is typically expected.

💡Commodity-like Characteristics

Commodity-like characteristics refer to the properties of a product or service that are similar to commodities, such as being interchangeable and having a price determined by supply and demand. The speaker uses this term to describe money, suggesting that despite bankers' arguments, money does have some commodity-like features that can impact banking profitability.

Highlights

Banking as a whole has earned rates that are well beyond tangible Equity.

Banks can earn between 12 to 16 percent on tangible assets, which is a good business model.

Banks are a fantastic business against the long-term bond at two percent.

The speaker doesn't expect banks to go down to earning only three or four percent on tangible assets.

Bank stocks versus the S&P seem to be at 30-35 to 50-year relative lows.

The appropriate multiple for a business relative to the S&P will depend on expected returns on equity.

Banks are not a homogeneous group; some have earned two percent on assets without taking real risk for decades.

The speaker owns a couple of banks and thinks they are somewhat different than other businesses.

People always want a formula for investing, but it doesn't work that way.

What matters is the cash a business will produce and buying it cheaper than that valuation.

The economic characteristics of a business determine how much cash it will generate over the long term.

The speaker has seen all kinds of banks ruined due to poor management.

There have been many banks that have disappeared over time.

The speaker and Charlie have failed to properly diagnose banking, underestimating the good results that would happen.

Banks have earned a lot more money on tangible Equity than expected.

Banks have stretched out equity much further than was the case 20 or 30 years ago.

A number of banks have earned very high Returns on Equity in recent years.

If banks can keep employing more Equity at the same high rate, it's also difficult to sustain.

Transcripts

you know the world compounds very fast

uh

you know banking as a whole

has earned rates that are

well beyond untangible Equity you know

well beyond I think

what much more glamorous businesses have

earned in in recent years well banking

is a good business if you don't do dumb

things on the asset side I mean

basically and uh

it's a business that uh

the banks we own earn between

uh

the commercial Banks earn between 12

percent

and 16 or so uh on tangent not tangible

assets that's a good business it's a

fantastic business against the long-term

Bond uh you know at two percent uh if

you have a choice between a two percent

instrument and twelve percent instrument

which was going to win over time so so

if you ask me whether I think uh

uh banks are going to go down where they

only earn three or four percent on

tangible assets I don't think that'll

happen uh I wanted to uh ask you to

comment on the relative PE multiples of

Bank stocks versus the s p they seem to

be at

you know 30 35 to 50 year relative lows

to the s p and I was wondering if that's

a result of the market a change in the

Market's perception of the forward

growth rates of uh Banks or uh if if the

market is perceived that there's a

change in Risk there

you asked by the performance of what

group compared to the s p uh Banks Banks

well

and and what was your assertion about

the performance historically well the

relative multiple of Bank stocks versus

the s p back in the 40s 40s 50s 60s they

commonly traded it say one times in s p

multiple and now they're maybe half that

one yeah Harry Keith used to have a lot

of figures on this and

I don't really think about uh about them

I mean the the appropriate multiple for

a business

relative to the s p will depend on what

you expect that business to achieve in

terms of Returns on on equity and

increment incremental Returns on

incremental equity

versus that s p i mean you've got if

you've got two dying types of businesses

and we'll say the s p earns Exxon equity

and and can deploy an additional amount

of capital at Y and then you compare

that with any other business and that's

how you determine which one is cheaper

uh

I would not characterize all banks as

the same I mean we have in this room

John four lines who runs the bank of

granite Granite North Carolina and

they've earned two percent on assets

without taking any real risk for decades

and it's a tremendous record and then

you have other banks that have been run

by

people that took them right into the

ground I mean that whether it was first

Pennsylvania going back 30 years ago I

think was John Bunning and they I mean

they they're not a they're not a

homogeneous

a group we own a couple of shock in a

couple of banks we own stock in m t that

has an exhibit downstairs today we own

stock in Wells Fargo

and

we think those institutions are somewhat

different than than other businesses so

I don't think there's a it goes back to

that earlier question people always want

a formula you know they I mean they go

to the intelligent investor and they

think you know somewhere they're going

to give me a little formula and then I

can plug this in and then I'll make lots

of money and it really doesn't work that

way what you're trying to do

is look at all the cash a business will

produce between now and Judgment Day

and discounted back at a rate that's

appropriate and then buy it a lot

cheaper than that and uh it whether the

money comes from a bank whether it comes

from an internet company or whether it

comes from a brick company

the money all spends the same now the

question is what are the economic

characteristics of the internet company

or the bank or the brick company that

tell you how much cash they're going to

generate over long periods in the future

and I would come to very different

answers

you know on M T Bank versus some other

bank so I wouldn't want to have a I

wouldn't want to have a single yard

sticker you know relative PE that I went

by uh I think that

banks have sold

uh a good many banks have sold at very

reasonable prices we bought all of a

bank in 1969 we bought a bank in

Rockford Illinois Charlie and I went and

looked at we must have looked at a half

a dozen banks at that

you know on a two or three year period

absolutely yeah we we trudged around and

and we found we found some very Oddball

banks that we liked uh and they were

characterized by uh by very little risk

on the asset side and very cheap money

on the deposit side

and even Charlie and I can understand

that

um and and low prices incidentally too

and then they passed the bank holding

company act in 1969 and and they killed

off our chances to do anything further

in buying all of banks so we look at

Banks we will own bank stocks from time

to time in the future we'll probably buy

stock in other Banks we've also seen all

kinds of banks ruined

I think it was

what was the fellow M.A Shapiro the uh

you came up with the statement he said

there are more Banks than bankers

and if you think about that a bit you'll

see what I mean uh

there have been a you know there have

been a lot of people

that have run banks in the very in

judicious manner but that's made for

opportunities for for other people the

uh there a lot of banks have disappeared

over time I mean up in Buffalo where

where Bob wilmer's runs m t uh

uh there were some other very

prestigious institutions that that went

right down the tubes and a lot of that

happened

in the early 90s or late 80s so I

I wouldn't look for a single metric

like relative PES to determine what how

to invest money at uh you really want to

look for things you understand

and where you think you can see out for

a good many years in a general way as to

the cash that can be generated from

business

and then if you can buy it at a cheap

enough price compared to that cash

it doesn't make any difference with the

name of it attached to the cache is

Charlie

yeah I think the questioner is

maybe even asking the wrong people that

question

I I would argue that Warren and I have

failed to properly diagnosed banking

I think we underestimated the general uh

good results that would happen because

we were so afraid of what non-bankers

might do when they were in charge of

banks

there are a number of banks that over

the last five or six years

untangible net worth the number of them

have a lot of Goodwill but untangible

net worth have earned over 20 on equity

you would think that would be difficult

for an industry to do

dealing in a commodity like money and of

course the bankers will argue it's not a

commodity but a lot of commodity-like

characteristics and you would think

those kind of returns

in a world of

six percent long-term interest rates and

much lower you'd think that would be

very hard to

well you you would have thought it

wouldn't have occurred you think it'd be

hard to sustain we've we've been wrong

in the sense that that

banks have earned a lot more money on

tangible Equity than Charlie and I would

have thought possible now I think to

some extent they've done it because

they've stretched out equity

much further than was the case 20 or 30

years ago I mean they they operate

with more dollars working

per dollar of equity than and then

people thought was prudent 30 or 40

years ago but however they've done it

they've earned a number of banks have

earned very high Returns on Equity uh in

recent years and if you earn high enough

Returns on equity and you can keep

employing

more of that Equity at the same rate

that's also difficult to do you know the

world compounds very fast uh you know

banking as a whole

has earned rates that are

well beyond untangible Equity you know

well beyond I think

what much more glamorous businesses have

earned in in recent years and Charlie

you have any further thoughts on that

all right

I say again we've

we didn't diagnose it as a

actually turned out

and uh even worse than that we haven't

changed

and even worse than that we won't