Why Warren Buffett Likes Financials

Consider including financials in your portfolio for solid, long-term returns

   
Why Warren Buffett Likes Financials

Warren Buffett is the fourth richest person in the world, a self-made billionaire investor, with a very large following. He is well-known for turning struggling textile manufacturer Berkshire Hathaway (BRK.B) into a $300 billion conglomerate, through investing in sound companies including Coca-Cola (KO), American Express (AXP) and Geico.

Warren Buffett especially likes to have Berkshire Hathaway invested in financials.

Banks

In particular, one of Berkshire Hathaway’s largest holdings is the bank Wells Fargo (WFC). Berkshire Hathaway has been holding onto WFC for a little under two decades.

As I was looking over Wells Fargo’s annual reports, I realized the reason why Warren Buffett likes that bank so much. WFC, along with most banks, receives cash from depositors without having to pay much interest at all. Then, those banks use that nearly-free capital to make loans to creditworthy borrowers and profit from the spread.

The other factor that helps Berkshire Hathaway’s investments in banks such as Wells Fargo and Bank of America (BAC) is the nature of customer relationships. If you bank with WFC, you are more likely to consider it when you need a loan for a new car, house, or to start a business. In addition, you are exposed to Wells Fargo’s cross-selling of investment services and credit card services.

Unfortunately, Berkshire Hathaway cannot acquire a bank outright due to current U.S. regulations. Hence, its ownership in the bank is limited to having a partial ownership interest. However, the lessons should provide an interesting model for investors as they consider including banks in their portfolios.

As discussed in my Aug. 4 article on dividend growth stocks, I recently decided to consider Warren Buffett’s stance on investing in financials and added to my position in Wells Fargo. I also sold some long-dates puts on the bank and expect to ultimately build my WFC position out slowly over time.

Insurance

Warren Buffett’s knowledge of insurance business started accumulating in the 1950s, after Berkshire Hathaway purchased Geico and Western Insurance. In the late 1960s, Berkshire Hathaway acquired National Indemnity and has been investing in insurance companies ever since.

Warren Buffett liked insurance companies because of their floats. Per Warren Buffett’s words:

“Insurers receive premiums upfront and pay claims later. … This collect-now, pay-later model leaves us holding large sums — money we call “float” — that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit. …”

Insurance companies usually use profit from float and invest it in safe instruments such as government or corporate bonds. If an insurance company ends up paying out less in claims than the premiums it receives, then it turns an underwriting profit. If that insurance company can at least maintain a breakeven point on insurance proceeds and a stable level of premium amounts with its free capital, then it can set itself up in a solid position to deploy at higher rates of return.

Most insurance companies keep selling insurance even if they are no longer compensated well for the risk. Berkshire Hathaway, however, only does this when it expects to at least earn some money on the policies. Taking a future, potential liability, without being properly compensated, could lead to losing money and shareholder equity.

Results from insurance operations can be lumpy, and so are earnings from bank operations. Financial crises do happen, which can lead to dividend cuts, but I believe that financials like Wells Fargo will continue to be good investments for patient, long-term shareholders with a 30-year time horizon.

After all, while there is obsolescence in many industries, financials will always exist. Financials that have prudent management, provide loans to creditworthy borrowers, grow customer relationships and thus earn recurring revenues, will continue to succeed despite any short-term economic turmoil. Therefore, financials are the lifeblood of the economy and are smart investments to include in any long-term portfolios.

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Article printed from InvestorPlace Media, http://investorplace.com/2014/08/why-warren-buffett-likes-financials/.

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