Thursday, October 25, 2012

Buffett on Banks: CNBC Interview

CNBC's Becky Quick interviewed Warren Buffett yesterday.

Interview With Warren Buffett: CNBC Transcript

Earlier in the interview, Buffett said that:

"I think the stock market generally is the best place to have money..."

Then he added:

"...there's no question that worldwide there is some slowing down going on."

He also made the following comments about Wells Fargo (WFC), U.S. Bancorp (USB), and banking in general:

"In the last week, I bought some Wells Fargo."

Then he later said...

"But we only have 430-something million shares, so I didn't feel we had enough."

Here's his explanation why banks won't be as profitable (and basically shouldn't be if you want a safe and sound financial system) as they were (or at least seemed to be) going forward.

"The profitability of banking is a function of two items. Return on assets and assets to equity.

And return on assets is not going to go up particularly. USB has done the very best on that. They're at about 1.7 percent. Wells is between 1.4 and 1.5 percent. But most banks are lower. Now, if you have 20 times leverage and you're getting 1.5 percent on assets, you're making 30 percent on equity.

And that was not lost on people a few years back. And they pushed balance sheets, and they're still pushing them in Europe. But they've cut back on that here. So they will not be having the leverage in the banking system. It'll be even more restricted among the bigger banks as part of the new rules, and you won't be able to earn more on assets than before, and so with less leverage in the same return on assets, you will have a lower return on equity. Banks were —banks were earning 25 percent on tangible equity not so many years ago. And really, that's kind of a crazy number. You know, for a basic semi-commodity business, you really don't want to allow that."

Yet it was allowed. Then we all had the great misfortune to see what happens when huge leverage is combined with the use of other people's money guaranteed, explicitly or not, by the government and a lack of sensible oversight. More from Buffett:

"...people got to push and push it and push it, and then the government says, 'Listen, we got a vested interest in this. You're using our credit, in effect, and if you want to play, you're only going to have 10-to-1, or some number like that.' So the returns on banks have come down. It's still a good business."

A well run bank can still be a good businesses. He added that "...Wells is very well run. And it's a good business."

A bank with 10x leverage* that can generate 1.4 or 1.5 percent return on assets (ROA) naturally has a mid-teens return on equity (ROE).

That math is simple but I think it is fair to say investing in most banks is far from easy to do. A bank that has mid-teens ROE bought near book value should**, in the long run, produce something like mid-teens returns for shareholders.

Should, that is, if (and it's a big IF) the bank can keep itself from getting into trouble down the road (unstable funding sources, insufficient liquidity, unwise investments/trades, dumb lending practices, foolish use of derivatives, etc.) that ends up wiping out all or part of the bank's per share value for common shareholders.

With leveraged institutions, an awful lot value can be destroyed in a very short amount of time (as we saw not all that long ago).

One of the weaknesses of some banks is that they lack the core earnings capacity of a Wells Fargo or U.S. Bancorp.

Wells Fargo's ROE in the most recent quarter was 13.4 percent.

U.S. Bancorp's ROE in the most recent quarter was 16.5 percent.

Whether they'll earn those kind of returns over the long haul can't really be known but it does provide some indication of relative capacity to earn.

In contrast, with similar leverage, some other banks seem likely to, post-financial crisis, have persistent below double-digit ROE (this starts with having inherently inferior ROA then not being able amplify with leverage as much). To me, that's generally an insufficient return for what are still, even if less so than before the financial crisis, by their nature rather leveraged institutions.

The problem isn't just that the returns are subpar considering the risks.

The problem is more that banks with lower returns have less capacity to absorb credit and other losses (lower pre-tax pre-provision earnings for every dollar of assets).

Once the next inevitable economic downturn or financial crisis occurs, those banks generating lower returns, all else equal, are likely the less durable institutions (from a common shareholder perspective that is). It takes less stress to begin weakening their balance sheet and more easily results in the need to raise capital (or worse). Since stressed financial institutions usually have to raise capital when the share price is quite cheap, it usually ends up being materially dilutive, and very expensive, for existing shareholders to say the least.

The returns of a bank should be considered in the context of their ability to withstand potentially severe economic and systemic stress. Like any investment, buying common shares of a bank requires a  margin of safety. Yet, with a weaker bank, simply adjusting the estimated intrinsic value lower by some percentage or buying with a bigger margin of safety to arrive at an appropriate price to pay is usually not enough. Eventually, it's more a go/no go decision. There's a threshold where it's just better to avoid the common stock of weaker banks altogether no matter how cheap they may seem.

A higher quality bank, though selling at a seemingly more expensive share price, may be intrinsically well worth the additional multiple of earnings or book value that must be paid.
(Only up to a point, of course. Margin of safety is still all-important.)

The bottom line is reduced earnings capacity relative to assets can significantly increase the risk of permanent capital loss for the common shareholders of a financial institution. Like any commodity/semi-commodity business, it's better to own the one's that will still be profitable in tougher environments when their weaker competitors are struggling to do so. The stronger banks are not just less likely to destroy intrinsic value during periods of economic stress (when credit losses are at their highest). The one's in a position of strength should also be able to make strategic moves that actually increase intrinsic value while weaker competitors are in retreat.

So it's not just that Wells or U.S. Bancorp generate higher returns, it's that they should be able to do so at less risk. It's their relative and absolute capacity to absorb losses from loans/ investments/ trades that go sour (and other liabilities that may arise). Ultimately, they earn superior returns (via various fees, gains, interest income) on their deposits (generally lower cost stable funding) than many competitors.

To a certain, but limited, extent those comfortable reading financial statements should be able to figure out if a bank has an advantage in this regard. Yet, annual/quarterly reports and other filings is unlikely to tell the whole story. Unfortunately, investing in any bank requires a subjective judgment (some might say a leap of faith) about the quality of management and the culture of the institution. In other words, there's no way that all the possible troubles a bank may get into will be obvious just from reading SEC filings. That's true of any enterprise but, considering the leverage involved, misbehavior or stupidity has the potential to be much more expensive for a bank shareholder.

Wells and U.S. Bancorp may not be as complex as some other large banks, but they are still hardly simple to analyze.***

Later in the interview, Buffett added this on the European banks:

"The European banks still are leveraged to an extraordinary extent... But they aren't earning 1.5 percent on deposits either."

Some European banks not only still have too much leverage but also don't earn nearly as much on their deposits (and some have funding that's of lesser quality). So they are not just riskier investments because of the excessive leverage. They are also riskier because their inherently inferior earnings provides them with less ability to absorb losses before the balance sheet, and eventually per share intrinsic value, takes a hit.

Adam

Long positions in WFC and USB established at much lower than recent market prices.

* 10x is far more reasonable leverage for a sound bank (those with lots of stable deposits, outstanding liquidity, high quality equity capital, sound underwriting practices, etc.) compared to what was often the norm before the financial crisis.

** Assuming the market price of the shares in the very long run can be sold at or above book value. That's not an unreasonable assumption for a well run bank. The intrinsic value of the better banks should be comfortably higher than book value. Wells and U.S. Bancorp are no longer selling below book value and certainly not below tangible book value. There were, however, a number of occasions in recent years when shares of both banks were selling for less than their per share tangible book value. Also, any share repurchases, especially if comfortably below intrinsic value, will boost returns above what their ROE suggests.
*** There are many simpler investment alternatives with less difficult to gauge risks and reduced likelihood of big mistakes. Investing in a bank's common stock certainly require a lot more work than, say, one of my favorite minimally leveraged consumer businesses. The question is whether there's a good chance they will produce materially greater long-term risk-adjusted returns considering all that extra work. An investment with greater complexity that requires more effort should be plainly worth the trouble. For me, sometimes they have been worth the additional effort but it's often a closer call than I'd like it to be. In other words, considering the alternatives, I'm not sure investments in even the highest quality financial institutions frequently pass the "plainly worth the trouble" test. There are many other, relatively unleveraged, potentially sound investments available. With that in mind, it seems unwise for an investor to put capital at risk in the common stock of a bank unless they're highly confident in their ability to judge financial institutions.
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