Too Big to Understand
With all due respect to Mr. Buffett, the fundamental problem with financial service firms is that they are too hard to value and too hard to understand. I love buying cheap companies, but when firms are highly leveraged, are allowed to value assets using non-market methods, and offer many products as “financial supermarkets,” they are not worthy candidates for stock picking.
To make this clear, let’s think about the qualities of stocks that would make them good candidates for fundamental analysis. First of all, since most investors use financial statements as a basis for understanding a company, the firm must have reliable financial reporting. This is inconsistent with mark-to-model accounting, which allows for tweaking valuation models to enhance asset values and net income.
Next, a firm must not be too complicated. If it’s too complicated an investor’s valuations for the stock are more likely to be wrong. More complexity means there are more opportunities for risk to creep in. More complexity also makes the company harder to manage. Worse yet, the wilder the product, the harder it is to understand if anyone is actually buying it or if consumers can sustainably buy this product in the future.
Buffet Bank Clarity, Safety
Berkshire Hathaway Inc. Chief Executive Officer Warren Buffett recently assured the public that there was minimal risk that banks would fail. Berkshire has invested heavily in more than four of the biggest U.S. banks and Buffett indicates that the lenders have rebuilt capital and they do not put the stability of the economy at risk. Berkshire has holdings in Wells Fargo, U.S. Bancorp, and Bank of America in addition to $5 billion warrants to buy stock of Goldman Sachs. Buffett is confident that banks are faring well considering the fact that Berkshire’s holdings increased in value after restoration measures were implemented after the crisis. Measures that have been put in place to guarantee the stability of banks, including job cuts and trading assets. According to Buffett, “Our banking system is in the best shape in recent memory.”
Buffett supports the idea of large banks, saying that it is important that banks match up to the size of capital markets. The biggest firms in Canada, for instance, performed better during the crisis, yet they hold a larger market share compared to their counterparts in the U.S. Investors are worried, as can be seen by how shares of many large financial services stocks, including Citigroup and Goldman Sachs, are trading at prices that are below book value.
Buffett indicated that Berkshire would redeem its preferred stock if the banks exercised their call options. The company also has warrants to buy common shares that may generate about $3.2 billion in profits if exercised, but Buffett indicates that the company is in no hurry to make the quick gains. According to Buffett, “Nine years from now I would think that Bank of America as well as Wells Fargo & Company (NYSE:WFC) and probably the other major banks will be worth considerably more money than they are now.”
