Recent attention on Warren Buffett's stock picks has focused on his large Apple (NASDAQ:AAPL) position, which is newsworthy because it is the single largest position in Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) portfolio and also because it goes against his traditional views on technology stocks as being too hard to understand. However, a close reading on his current portfolio demonstrates that Buffett is making an even larger bet on big US banks.
As of December 31, four of the largest commercial banks - Bank of America (NYSE:BAC), Wells Fargo (NYSE:WFC), JPMorgan Chase (NYSE:JPM), and U.S. Bancorp (NYSE:USB) - made up 28% of Berkshire Hathaway's $183 billion portfolio - or approximately $52 billion. If you add in Berkshire's stakes in other financial companies and banks including American Express (NYSE:AXP), Bank of New York (NYSE:BK), Goldman Sachs (NYSE:GS), PNC Financial Services (NYSE:PNC), M&T Bank (NYSE:MTB), then the total goes to 41% of Berkshire's current equity portfolio. This article will focus on the three largest commercial banks, but nevertheless, Buffett is betting big on US financial companies.
Recently, Buffett was interviewed on CNBC and gave some insight on what he sees in the big banks. When asked about his financial holdings, Buffett responded:
They're very good investments at sensible prices, based on my thinking. And they're cheaper than other businesses that are also good businesses by some margin."
Buffett has previously said that "in the business world, the rearview mirror is always clearer than the windshield." It seems that Buffett sees the financial industry's future returns being much brighter in the future than our collective backward-looking view of financial institutions as weak and fragile investments.
When asked about his recent JPMorgan investment, Buffett expanded on why he likes banks:
you can find a bank like JP Morgan [that earns] maybe 15%, maybe 17%, even, on net tangible equity. A business that earns 15% or 16% or 17% on net tangible equity, that's incredible in a world of 3% bonds. I mean, just imagine that you had a deposit account with JP Morgan that they made a mistake and they gave you 15% on it. And they couldn't redeem it. What would you sell that account for? You wouldn't sell it for 100 cents on the dollar. You wouldn't sell it for 200 cents on the dollar. You wouldn't even sell it for 300 cents on the dollar. You have an FDIC-guaranteed instrument that would now be at 300 cents on the dollar. If it was 15% on equity, you'd be earning 5% on it, which is way better than treasuries. Now, if on top of that, your deposit allows you to let your interest compound to some extent, now, that instrument becomes even worth way more. Because if you have an instrument that could compound at 15% for ten years and use the added capital, that's worth way more than three times tangible equity at current interest rates, way more"
Buffett is saying here that with the way banks are currently earning, they should be worth at least 3 times tangible book value in a world with low interest rates. Currently, Bank of America and Wells Fargo have a price to tangible book value of 1.6 times and JPMorgan has a price to tangible book value of 1.9 times. So, Buffett is saying that if the banks earn about 15% on tangible equity, Bank of America and Wells Fargo should be worth at 90% more than their current price and JPMorgan should be worth at least 35% more than its current price.
Buffett also mentioned three other factors that make banks good investments now including that 1) banks are buying back lots of their shares while their shares are underpriced, 2) the recent tax legislation dramatically increased the earnings power of banks, and 3) the banking system is much safer now than it used to be.
Buffett said in the 2018 annual letter to shareholders:
All of our major holdings enjoy excellent economics, and most use a portion of their retained earnings to repurchase their shares. We very much like that: If Charlie and I think an investee's stock is underpriced, we rejoice when management employs some of its earnings to increase Berkshire's ownership percentage."
This certainly applies to the big bank shares. Buffett thinks bank shares are cheap and the banks are certainly buying back lots of shares. From June 2018 to June 2019, Bank of America is repurchasing $22.5 billion of its shares. At today's market cap of $285 billion, that would be about 8% of all shares outstanding. In 2018, Wells Fargo repurchased $17.9 billion of its shares, reducing its share count by 6%. In 2018, JPMorgan repurchased $19.3 billion of its shares, reducing its share count by 4.5%. All of these banks expect to continue repurchasing their shares for the foreseeable future.
As for the new tax bill, Buffett explains in his annual letter what the implication of the tax bill has been for Berkshire Hathaway shareholders and the shareholders of almost all of Berkshire's equity holdings, including the big banks:
Begin with an economic reality: Like it or not, the U.S. Government 'owns' an interest in Berkshire's earnings of a size determined by Congress. In effect, our country's Treasury Department holds a special class of our stock - call this holding the AA shares - that receives large "dividends" (that is, tax payments) from Berkshire. In 2017, as in many years before, the corporate tax rate was 35%, which meant that the Treasury was doing very well with its AA shares. Indeed, the Treasury's "stock," which was paying nothing when we took over in 1965, had evolved into a holding that delivered billions of dollars annually to the federal government" Last year, however, 40% of the government's "ownership" (14/35ths) was returned to Berkshire - free of charge - when the corporate tax rate was reduced to 21%. Consequently, our "A" and "B" shareholders received a major boost in the earnings attributable to their shares."
Substitute any of the big banks for Berkshire Hathaway above - Wells Fargo, Bank of America, and JPMorgan - and the result is the same. The tax law, which, of course, could be changed by Congress at some point, results in a huge "buyback" in the sense that the current shareholders get to keep more of each dollar in earnings. Because the big banks are mostly US based and have not had the opportunity to reduce taxes like many multinationals have in the past, the tax law benefits the big banks more than many other large companies that have an international focus.
The final point made by Buffett on the banks was on the safety of the banking system. He said:
There were [previously] special FDIC charges on the big banks. They ended here, recently. Because the FDIC has $100 billion in it now. That money has all come from the banks. The U.S. government has not put any money in the FDIC. People think that you know, that somehow, the FDIC is financed by the government. It's guaranteed by the government. But the FDIC was started in, I think, January 1, 1934. And I think, one time, it borrowed temporarily. But it doesn't have a dime of government money in it. That money - and now, they've got $100 billion in there. And the banks are much better off. Because that fund takes care of the bank here and there that goes broke. Incidentally, last year, was no bank in the United States, no FDIC bank, went broke. That's the first time in a long time."
So, the FDIC has $100 billion and there were no bank failures in 2018. That suggests the banking system is a lot stronger and lower risk than it has been for a long time.
So, Buffett's thesis on banks is that 1) bank stocks are cheap as they should trade at 3 times tangible book value or higher given an on-going return on tangible equity of 15% or higher, 2) the large share repurchases made by the banks below intrinsic value have huge benefits to long-term shareholders as earnings per share increases rapidly, 3) the tax law further increases the earnings per share of shareholders in bank stocks, and 4) the banking system is currently in great shape and banks are safer than they have been for a long time.
The rearview mirror of the last 10 years has led most people to believe that banks are too risky to be sound long-term investments. However, things have changed. The big surviving banks have gotten bigger and stronger. The regulations put in place after the great recession have made the overall banking system safer. The fear around bank stocks should keep the price of shares reasonable over time leading to share repurchases being more effective in reducing share count. The tax law has increased the earnings power of banks for the foreseeable future. Two additional factors not mentioned by Buffett that should benefit the big banks moving forward are 1) interest rate increases should provide a tailwind to bank earnings and 2) the industry is much more concentrated than it was prior to the Great Recession and industry concentration usually leads to increased profitability for all participants. This is a good time to take advantage and buy big US banks for the long-haul.
Disclosure: I am/we are long BRK.B, WFC, BAC, JPM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.