"More Banks Than Bankers"
Note: TSOH will be off next week. I’ll be back October 10th with the Q3 FY22 Portfolio Update. As always, feel free to contact me if you need anything.
At the 2002 Berkshire Hathaway annual meeting, Warren Buffett and Charlie Munger were asked how they determine the appropriate P/E multiple to pay for a stock. In their response, the men took the opportunity to discuss their history with investing in banks, along with some of the surprising results – in a good way – that they’ve observed in that business (edited for brevity):
Buffett: “The appropriate multiple for a business, relative to the S&P 500, will depend on what you expect that business to achieve in terms of returns on equity and incremental returns on equity versus the S&P 500. If you’ve got two types of businesses - we’ll say the S&P earns X on equity and can deploy an additional amount of capital at Y - then you can compare that with any other business to determine which one is cheaper. I would not characterize all banks as the same… They’re not a homogeneous group… What you’re trying to do is look at all the cash a business will produce between now and judgment day, and discount it back at a rate that’s appropriate, and then buy it a lot cheaper than that. And whether the money comes from a bank, an internet company, or a brick company, it all spends the same. Now, the question is, what are the economic characteristics of the internet company or the bank or the brick company that tell you how much cash they’re going to generate over long periods in the future… Charlie and I must have looked at half a dozen banks in a two or three year period. We trudged around and we found some very oddball banks that we liked. And they were characterized by very little risk on the asset side and very cheap money on the deposit side. Charlie and I can understand that. And low prices, incidentally, too… We’ve also seen all kinds of banks ruined. I think it was Morris A. Schapiro who came up with the statement, ‘There are more banks than bankers.’ There have been a lot of people that have run banks in a very injudicious manner, but that’s made opportunities for other people… You really want to look for things you understand, where you think you can see out for a good many years, in a general way, as to the cash that can be generated from the business. If you can buy it at a cheap enough price compared to that cash, it doesn’t make any difference what the name attached to the cash is.”
Munger: “I think the questioner may be asking the wrong people that question. I would argue that Warren and I have failed to properly diagnose banking. We underestimated the generally good results that would happen because we were so afraid of what non-bankers might do when they were in charge of banks.”
Buffett: “There are a number of banks that over the last five or six years, on tangible net worth, have earned 20%+ on equity. You’d think it would be difficult for an industry to do that dealing in a commodity like money - and, of course, the banks will argue it’s not a commodity - but it’s got a lot of commodity-like characteristics… We’ve been wrong in the sense that banks have earned a lot more on tangible equity than we would have thought possible. Now, to some extent, they’ve done that because they stretched out equity much further than was the case 20 or 30 years ago. They operate with more dollars working per dollar of equity than people thought was prudent 30 or 40 years ago. But however they’ve done it, a number of banks have earned very high returns on equity in recent years. And, if you earn high enough returns on equity and you can keep employing more of that equity at the same rate - that’s also difficult to do - the world compounds very fast. Banking as a whole earned rates on tangible equity well beyond what much more glamorous businesses earned in recent years.”
Munger: “We didn’t diagnose it as it actually turned out…”
Apologies for the long excerpt, but I think it does a good job of framing today’s discussion. For many of today’s investors, the idea of investing in financials, and particularly in banks, undoubtedly stirs up some very bad memories – most notably as it relates to what happened during the Global Financial Crisis of 2008 – 2009. During a speech in March 2009, Seth Klarman spoke about how difficult experiences like the GFC, when they occur early in an investor’s career, can influence their views for years to come:
“I graduated from business school in 1982; the world in 1982 was extremely different than the many years after that… We had very high interest rates… The stock market, a little bit like today, was down in the dumps; the Dow was trading in the 700’s and had done nothing for 18 years… no one was graduating business school to go into Wall Street. I’ve often thought that people’s temperament in the business is colored by the day they come into the business. If you started in 2005 or 2006, you were probably influenced by the optimism of those markets. If you came in in 1982 or in 2009, you’re influenced by the pessimism of those markets. It affects you. If you remember how cheap things can get, you don’t easily forget that lesson.”
What brought this topic to mind for me was a recent report by the team at J.P. Morgan Asset Management (“The Agony & The Ecstasy 3.0”). The purpose of the report was to examine the risks associated with concentrated portfolios, most notably as it relates to business survival risk (i.e. terrible outcomes). In the report, the team pulled data for the different sectors of the Russell 3000 to paint a picture about the experience of its constituents over the previous four decades (1980 to 2020). The output, reprinted below, sheds some light on the outcomes (performance) for each of these sectors during that time period.