Why Berkshire Owns Banks And Why I'm Buying Berkshire

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Richard J. Parsons
5.69K Followers

Summary

  • Bank stocks are out-of-favor in today's market, and consequently, valuations are favorable to 40-year averages.
  • While short-term bank returns will be volatile, history suggests that today's valuations should yield 200-300% total returns over the next 10 years.
  • Bank stocks comprise 42.6% of Berkshire Hathaway's equity holdings as of June 30.
  • While holding a big position in bank stocks, Berkshire Hathaway also has $122 billion in cash that provides downside support for a market decline as well as ample capital for future investment opportunities.
  • I am buying Berkshire Hathaway for exposure to large bank stocks and a hedge against a market rout that could provide Buffett with an opportunity to make one of his extraordinary deals.

Background

In this post, readers will discover that total bank returns and valuations are not correlated in the short term but highly correlated long term. Current bank valuations should be attractive to investors with a long-term buy-and-hold investment style.

In addition, readers will gain a better understanding why Warren Buffett and Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) have made an outsized investment in bank stocks in 2018-19. Patient investors like Buffett can have a reasonable expectation that total returns for bank stocks over the next 10 years should be in the range of 200% to 300%.

Of course, investing in bank stocks is not without risk which explains why investors are currently shunning bank stocks and why valuations are favorable to historic trends.

Methodology And Historic Price To Tangible Book Value

Total returns (dividends plus price appreciation) for 40 banks have been studied since 1990. For the purpose of this analysis, bank valuation is defined as the median Price to Tangible Book Value (P:TBV) of the 40 banks for the five time periods studied. The smallest of the 40 banks is $13.6 billion Mississippi-based Trustmark Corp. (TRMK). The largest is $2.7 trillion JPMorgan Chase & Co. (JPM).

Chart 1 shows the median Price:TBV of the 40 banks by month since January 1990. The 40 banks have had an average month-end P:TBV of 2.12 over the past 40 years. The August 12 median ratio is 1.65, down from a post-Financial Crisis high of 2.25 in January 2018.

To be clear, a 1.65 median P:TBV is not downright cheap. Since 1990, banks plumbed their lowest valuations during the great bank recession of 1990-91 (when Buffett made his first investment in the old Wells Fargo which was eventually taken over by Norwest) and in 2011 (when Buffett went long on Bank of America). Since 1990, bank stocks have been valued below 1.65 about one-third of the time.

Chart 1

Buffett And Banks

At the end of Q2 2019, banks comprised 42.6% of Berkshire Hathaway’s investment portfolio as reflected in chart 2. During the past 18 months, Berkshire has taken positions in JPM and PNC Financial Services Group (PNC) as well as added to holdings in Bank of America Corporation (BAC) and US Bancorp (USB).

Chart 2

Historic Total Returns Over Short And Long Term

Chart 3 reinforces a message I conveyed in my May 4 article about the Regional Bank ETF (KRE): Short-term returns in bank stocks are highly random, and therefore, it is folly to buy a bank stock or bank ETF if an investor does not plan to own the equity for a long time.

Note in Chart 3 that the R-square for 3-month total returns is .002. In other words, short-term bank returns are random regardless of bank valuations.

Chart 3

While investors improve the odds of getting a favorable total return by increasing their holding time of bank stocks to 1 year, as Chart 4 shows, the R-square is still low at .1975. 1-year bank investors cannot have great confidence of a positive total return at virtually any valuation entry point, although odds of a favorable outcome are better at lower valuations than higher.

Chart 4

Bank investors with a 3-year time horizon can with some confidence expect to see a relationship between valuation and 3-year returns as shown in Chart 5. However, an R-square of .4817 (correlation of roughly 70% squared), while clearly superior to investment horizons less than 3 years, is still not statistically significant for the cautious investor seeking to manage downside risk. A 3-year bank investment horizon does appear to insulate investors to a fairly large degree against an actual loss of principal provided the bank stocks are purchased at a median P:TBV of no greater than 1.8.

Chart 5

By moving the bank investor horizon to 5 years, the R-square improves significantly to .6641. Even a casual eyeballing of the data in Chart 6 shows a clear relationship between historic return and valuation. Bank investors with a 5-year horizon can with some confidence expect a positive total return provided banks are bought at a P:TBV of less than 2.0. In contrast, investments made when bank stocks have a P:TBV greater than 2.5 have failed about 50% of the time since 1990 to have produced a positive total return.

Chart 6

Chart 7 is the money chart as it shows a statistically strong R-square of .8073 (a correlation of roughly 90% squared) between valuation and 10-year total returns. Over 10 years, statistically speaking, about 81% of the total return of bank stocks can be explained by valuation at the time of the bank stock purchase.

When the median P:TBV of the 40 banks has been 1.6 to 1.7 since 1990 as it is in mid-August 2019, total returns over the next 10 years have historically been between 200% (tripling the initial investment) and 300%. It is worth noting that the odds of negative total returns appear negligible at today’s valuation.

Chart 7

Closing Thoughts

  1. Making short-term bets on bank stocks is just that: A bet.
  2. Bank investors should not buy a bank stock if one does not have the stomach to own the bank for 10 years.
  3. An R-square of .8073 for investors with a 10-year horizon is strong, however, it is not a perfectly linear correlation. Investors should understand that even a 10-year horizon does not eliminate the potential for unexplained (both favorable and unfavorable) variance to expected total return.
  4. While a bank investor can buy a bank ETF or mutual fund (KRE, KBE, FRBAX, IAT, FNCL, XLF) and presumably achieve returns similar to those outlined in this analysis, my personal preference, like Buffett, is to pick and choose individual banks that have certain characteristics as I have outlined in prior posts on these pages. See my 2019 post about "12 High Quality 'Buffett Banks.'" I believe it is possible to reduce risk (defined as volatility of return) over time by investing in a group of 10-20 banks of varying sizes, geographies, and business models that have demonstrated a strong ability to generate superior Risk-Adjusted Returns on Equity.
  5. If all goes as planned, in the coming days, I will share with the Seeking Alpha community my recently completed analysis of 2Q 2019 bank performance data.
  6. Regarding risks, today’s historically favorable valuation for bank stocks suggests investors perceive heightened risk in owning bank stocks. My current view is that credit risk - the chief risk to bank earnings over time - continues to be well-managed. I also remain sanguine about traditional interest rate risk as I documented back in 2016 (see “No Free Lunch for Bank Investors”). However, I am more concerned about a type of interest rate risk that U.S. bank regulators, directors, and bankers have never experienced in the past. This risk likely will be discussed on these pages in the weeks ahead.
  7. Finally, for the record, in recent days, I have added modestly to my position in BRK.B, believing Berkshire Hathaway is priced attractively for long-term ownership. At $190-$200, Berkshire Hathaway is priced at roughly 1.2 times forecasted 12/31 Book Value. As I documented in my 2017 article about the history of Berkshire Hathaway valuation, a 1.2 Price to Book is historically low and likely a price point at which Buffett buys back shares. With 42.6% of its equity holdings in bank stocks plus a purse of $122 billion, Berkshire Hathaway represents a reasonably safe way to gain bank exposure as well as provide some downside protection if tariff wars escalate, GDP slows, and markets tumble short term.

This article was written by

Richard J. Parsons profile picture
5.69K Followers
Richard J. Parsons is a former banker who writes about the banking industry as well as market risk. He is currently working on his third book about banks. His first book, "Broke: America's Banking System" (2013, RMA), describes why the industry is prone to catastrophic cycles that produced 3,000 bank failures in the U.S. between 1985 and 2012. The second book, "Investing in Banks" (2016, RMA) examines why a small group of elite banks of all sizes consistently overperform the industry over time and through the ups and downs of business cycles. The new book will update "Investing in Banks" with data from 2016-2021. Parsons is a frequent contributor to The Risk Management Journal. He teaches the Advanced Operational Risk Management course for the RMA. Prior to writing and speaking about the banking industry, Parsons spent more than 31 years at Bank of America where he was an executive vice president and member of the Management Operating Committee. In his last role he chaired the bank’s Operational and Compliance Risk Committee and the Emerging Risk Committee. Parsons has a BA in history from Ohio Wesleyan University and an MBA from the University of Virginia Darden School of Business.
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Disclosure: I am/we are long BRK.B, 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.

Additional disclosure: Having retired from a 31-year career at Bank of America in 2011, though I currently have no equity holdings, i do have certain financial interests in BAC.

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