What Would Buffett Do? 3 Safe Financial Picks

There is much turmoil in current financial news, with large businesses revealing problems galore. This isn’t all news. Warren Buffett had dicussed the problems with derivatives for some time. He unwound the entire derivatives operation at General Re and has specifically avoided some banks over the years because their financials were too complicated and not understandable.

Now we see his intelligence again. These “complicated” banks are being forced to confess to poor management of their businesses over the last few years. Many of these banks made loans to people who really should not have received them and now these “assets” are being written down. This is really the banks saying ,"we made bad investments that are not worth near what we have been reporting on our balance sheet." The numbers are massive. These banks loaned billions of dollars that should not have been loaned and invested billions in subprime mortgages that cannot be paid off because the borrower does not have the capacity to pay the loan off .

So why was the loan written? Why did, as the CEO of Wells Fargo (WFC) said, “banks look for new ways to lose money when the old ways were working so well”? Banks had the ultra low Greenspan rates and the desire to push loans to grow to borrowers who wanted this cheap money. Essentially the supply of money was huge and demand met it. Unfortunately it was supplied to and demanded by unproductive investors who did not invest the money in such a way that the loan could be paid back. Indeed, many of the borrowers were just the average "Joneses" taking cheap money to acquire a bigger house to appear richer. Strangely, this worked until there was not a greater fool.

And now the ball has dropped. Unfortunately, some very irresponsible borrowing and lending has now come home to roost and the Main Street investor is paying. These banks are writing off the bad loans and their earnings will probably be down for some time. After all, why did medial people think this would be over in one write off? When you see one cockroach there are 100 in the walls.

What should we investors do? What investors need to do is be rational - know that this will pass - and it pays to be greedy when others are fearful.

I would be a buyer of financials over 2008, but I would be very choosy and only buy the best.

Who are the best? I would consider three based on some basic criteria.

1. Wells Fargo (WFC)

When I’m analyzing an investment, I first ask myself, “would Warren Buffett buy this company?” In this case, Warren is invested in the company. In fact, this company is the second largest stock investment in Berkshire Hathaway’s (BRK.A) (BRK.B) portfolio - second only to Coca-Cola (KO). And Berkshire made it that large of a position by adding more stock recently.

Second, the business is understandable and Wells will more than likely be a leader in banking ten years from now due to competitive advantages.

Finally, Wells Fargo has earned above average returns on equity for years. They also have historically strong earnings power. Buffett has said they probably won't achieve record earnings for years. However, they more than likely will earn record earnings again. Attached to a higher pie than exists today, you have a future record stock price.

2. US Bancorp (USB)

This is Buffett’s other bank. It also earns some of the highest returns on equity in banking. The bonus here is that this bank earns much of their revenue on a fee basis and is clearly not involved in the subprime mess the way Citigroup (C) and others are.

3. American Capital Strategies (ACAS)

This business development company is really an asset manager and growing its fee based business. They have increased their dividend every year since their 1997 IPO. They are a leader in private equity alternative investing with serious competitive advantages and are not significantly involved in the subprime debacle. In fact, as they say in the 2006 annual report:

Often, the most important investment decisions we make are the ones where we reject investment opportunities…we looked at a number of equity investment opportunities in sub-prime mortgage securitizations. However we rejected making investments in structured financial vehicles that included interest only prime and sub-prime residential real estate exposure.

These guys are good.

Remember, as the wise men said “this too will pass”.

Disclosure: Author owns ACAS, USB and BRK.B.

Comments

[EFI BEN-DOR]

The comment Mr. Buffett made about banks not making new highs was referring to some other banks who by the virtue of their misconduct will not be able to top recent earnings. He did not said that statement while referring to WFC.

[Turbo Grande]

Doesn't Mr. Buffet own BAC as well?

[Been there B4]

No position on any of the three, but it does not take much digging to find out who the big buyers of the subprime mortgages being brokered. It was Citi, WFC and Countrywide. Given the public declaration by WFC that they did not create SIV's from these, then it means the risk is in their portfolio of loans, not in the investment group like Citi. I will wait till it shakes out another quarter before going long.

[Alpha Seeker]

Warren is going to buy PetroChina again, but in smaller quantities, where he doesnt have to disclouse it. I also imagine he will look and possibly act on Krispy Creme.
Rob from www.WallastonInvestmen...

[BotanicusRex]

I expect he will have to disclouse it... especially if it's been around the waterfront bars in Shanghai

[Pilot Guy]

Good calls! Only two of three are down over 12% YTD!

[dectra]

I own all three, and have been picking up more ACAS as the price has dropped. Great company, Awesome dividend, and the ability to finance most of their own projects. What's not to like? (other than the fact that it's tarred with a 'financials' tag)

[tom mustric]

The short squeeze set up blinding investors for DIVX's spinoff and takeover leadership to seek cash from directors---sold at its low could only be a necessary business decision not a sale for a broken stock or company, as DIVX becomes a expanded brand--here in US, now in Europe, and expanding in PRC, future timed reports, further strategic vertical placement, may sets itself up for its own takeover.

[fernando]

wfc has $84B heloc exposure that they carry on their books at 94c on the dollar. how can you be sure they are not being upfront about the value of this portfolio?this a securities that have 0% recoveries, it could easly be only worth 50c and that would be a massive writedown for wells. meredith whitney is on the record saying wells will need to raise money...