2003: How does Buffett approach banking investments?

AUDIENCE MEMBER: Yes, hi. Sam Kidston. I’m a shareholder from Cambridge, Massachusetts. I have a couple of quick questions for you guys.

First of all, other than your general criteria for investing in any company, what are your criteria for investing in banks? And has your general view toward investing in banks changed over time?

Second question would be, in terms of a discount rate, do you feel it’s appropriate to use your cost of capital at the current risk-free rate?

And then in the past, you’ve mentioned that you do some sort of pseudo-bond arbitrage, and would you please specify what types of trades you do in this area?

WARREN BUFFETT: Oh, you would like our buys and sells for Monday morning? (Laughs)

We don’t — we’re not going to talk about specific strategies that, you know — we obviously they’re profitable or we wouldn’t be doing them, and we think other people might copy them if we talked about them, so —

And we have pointed out, incidentally, and we will continue to point it out, that there’s not a long life to these bond strategies. That doesn’t mean we might not reemploy them when circumstances called for it later on.

But they’re not like earning money out of See’s Candy or, you know, out of Fruit of the Loom or something. They’re opportunistic situations that we’re pretty well positioned to engage in at certain times.

WARREN BUFFETT: The question about banking, you know, banking — if you can just stay away from following the fads, and really making a lot of bad loans, banking has been a remarkably good business in this country.

Certainly, ever since World War II, it’s — the returns on equity from — for banks that have stayed out of trouble has really been terrific.

And there are many — there are certain banks, I should say — in this country that are quite large that are earning, you know, maybe 20 percent on tangible equity.

And when you think you’re dealing in a commodity like money, that’s fairly surprising to me.

So, I would say that I guess I’ve been surprised by the degree to which margins in banking have not been competed away in something as fundamental as money.

How about you, Charlie?

CHARLIE MUNGER: Well, what you’re saying, in fair implication, is that we sort of screwed up the predictions, because banking was a way better business than we figured out in advance.

We actually made quite a few billions of dollars, really, out of banking, and more in American Express. But basically that was while we were misappraising it.

We did not figure it was going to be as good as it actually turned out to be. And my only prediction is that we’ll continue to make failures like that. (Laughter)

WARREN BUFFETT: It’s fairly extraordinary, in a world of — particularly a world of low interest rates, that you’d find financial institutions basically doing pretty much the same thing, you know, where A competes with B, and B competes with C, without great competitive advantage, and having them all earn really high returns on tangible capital.

Now, part of it is that they push — they have pushed the loan-to-capital ratios higher than 30 or 40 years ago, but that — nevertheless they earn high rates of returns. They earn much higher rates of returns on assets alone, and then they have greater leverage of assets-to-capital so that produces returns on capital that really are pretty extraordinary.

And, you know, banks — certain banks — get into trouble because they make big mistakes in lending, but it’s not required of you, in that business, to get into trouble. I mean you can — if you keep your head about you, it can be a pretty good business.

WARREN BUFFETT: The question about a discount rate, when you talk about our cost of capital, that’s worth bringing up, because Charlie and I don’t have the faintest idea what our cost of capital is at Berkshire, and we think the whole concept is a little crazy, frankly.

But it’s something that’s taught in the business schools, and you have to be able to answer the questions or you don’t get out of business school.

But we have a very simple arrangement in terms of what we do with money. And, you know, we look for the most intelligent thing we can find to do.

If we’ve got money around or — if we look — we don’t buy and sell businesses this way, but in terms of securities we would — if we find something that’s at 50 percent of value, and we own something else at 90 percent of value, we might very well move from one to another. We will do the most intelligent thing we can with the capital we have.

And so, we measure alternatives against each other, and we measure alternatives against dividends, and we measure alternatives against repurchase of shares.

But I have never seen a cost of capital calculation that made sense to me.

How about you, Charlie?

CHARLIE MUNGER: Never.

And this is a very interesting thing that’s happened. If you take the most powerful freshman text in economics, which is by [Greg] Mankiw of Harvard, and he says on practically the first page that “intelligent people make their decisions based on opportunity cost.”

In other words, it’s your alternatives that are competing for the use of your time or money, that matter in judging whether you take action or not.

And of course, those vary greatly from time to time and from company to company. And we tend to make all of our financial decisions based on our opportunity costs, just as like they teach in freshman economics.

WARREN BUFFETT: Yeah.

CHARLIE MUNGER: And the rest of the world has gone off on some crazy kick where they can create a standard formula, and that’s cost. They even get a cost of equity capital for some business that’s old and filthy rich. It’s a perfectly amazing mental malfunction.

WARREN BUFFETT: Yeah, it’s a — (Laughter)