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Morningstar | Berkshire Hathaway Increases Bet on Banks and Other Financial Services Firms in 3Q

As we noted last week, wide-moat rated Berkshire Hathaway spent some $14 billion on the purchase of financial services stocks in the third quarter, with the sector accounting for 40.7% of Berkshire's reported equity portfolio at the end of September (much higher than the 13.8% financials weighting in the S&P 500 Index). The insurer's second largest sector weighting at the end of the third quarter was in technology, which accounted for 27.7% of Berkshire's equity portfolio, but much of that was by virtue of its large stake in narrow-moat Apple (which accounted for 25.8% of its equity holdings).

Berkshire's purchase of an additional 198.2 million shares of narrow-moat Bank of America for around $5.7 billion increased its stake to 8.9% of the bank's outstanding shares. The commitment of some $1.3 billion for an additional 24.3 million shares of wide-moat US Bancorp raised Berkshire's stake in that bank to 7.7%. With narrow-moat Goldman Sachs, Berkshire's purchase of 5.1 million additional shares for around $1.1 billion increased the insurer's stake to 4.9% of the investment bank's outstanding shares. And the purchase of 13.0 million more shares of wide-moat Bank of New York Mellon for about $685 million raised Berkshire's stake in the trust bank to 7.9%. With its new money purchases of narrow-moat JPMorgan Chase (35.7 million shares for some $3.9 billion), no-moat PNC Financial (6.1 million shares for $825 million), and narrow-moat Travelers Companies (3.5 million shares for $450 million) Berkshire closed out the third quarter holding 1.1%, 1.3%, and 1.3%, respectively, of these financial services firms' outstanding shares.

Of these names and Berkshire's other financial services holdings--wide-moat American Express, Visa, and MasterCard, narrow-moat M & T Bank and Torchmark, and no-moat Synchrony Financial--only Wells Fargo and Goldman Sachs are currently trading at steep enough discounts to out analysts' fair value estimate to recommend for long-term investors.

In Wells Fargo's case, the bank closed out last week trading at a 21% discount to our analyst's $67 per share fair value estimate. While the bank's hard-driving sales culture has overheated in recent years, as management incentivized increasing revenue at all costs, rather than focusing on improving its customers' financial lives, we have not seen a wholesale abandonment of Wells Fargo by its customers. Morningstar analyst Eric Compton believes that new programs focused on deepening active relationships should help to stabilize and improve revenue (and waste less employee time) than the overly ambitious product sales goals that drove the bank's top line in the recent past. He notes that Wells Fargo is still the top deposit-gatherer in the United States and that, as such, the bank has consistently paid less for balance sheet funding than most of its competitors, allowing it to generate more revenue per dollar of assets than most of its peers. Compton expects a rising interest rate environment and incremental efforts at deregulation to unleash earnings power as we move forward, even though we've not seen much of an increase in net interest margins of late as some of its peers (due to the fact that Wells Fargo has been repositioning its balance sheet). He also notes that unlike its main competitors, Wells Fargo is not a top player in the capital markets, with its business model, which is more akin to regional banks than to money center institutions, providing it with the scale advantages of a money center bank without the risks and volatility associated with extensive capital markets operations. While Compton admits that the potential for little to no revenue growth in the near to medium term is a drag on the firm, he believes that if the bank can control expenses and eliminate legal charges (with recent expenses falling in line with his expectations), Wells Fargo should be well on its way to regaining its past profitability, which would be a net positive for long-term investors.

And we wouldn't be overly concerned by Berkshire's decision to trim its stake in Wells Fargo during the third quarter. Barring a few exceptions in its portfolio--namely, wide-moat American Express and Moody's, narrow-moat DaVita and VeriSign, and no-moat Kraft-Heinz and USG Corporation (as well as some of its Liberty Media holdings)--Berkshire Hathaway has voiced its intention going forward to avoid owning 10% or more of any investee's shares. As many of these holdings are actively repurchasing shares, the insurer will to trim positions from time to time in order to avoid hitting this 10% ownership threshold, much as it continues to do with Wells Fargo, with Berkshire Hathaway selling another 9.6 million shares of the bank for an estimated $520 million during the third quarter.

With regards to Goldman Sachs, Morningstar analyst Michael Wong feels that the bank has been steadily making changes that should cause the market to revalue it higher over time. Management has made the company's investment management business a priority the past several years, with assets under supervision now exceeding $1.4 trillion the firm's investment management revenue has recently clocked in at around 20% of net revenue (compared with 11%-12% before the 2008-09 financial crisis). He notes that investment management is a relatively stable, high-return-on-capital business that is well suited to the current regulatory environment and should help offset some of the lumpiness in its capital markets operations. With the company's more traditional investment banking business, Wong notes that it is more of a game of attrition as well as looking for niches of incremental growth. Goldman Sachs remains the top global investment bank, and with many of the other investment banks in less advantageous positions (and some even restructuring their operations) he feels that Goldman Sachs is in an ideal position to pick up any business out there that might be up for grabs. He also highlights the company's current three-year plan aimed at increasing net revenue by $5 billion by focusing on some of its newer business lines as well as customer segments that it hasn't historically targeted. With the shares closing out last week trading at a 22% discount to his $258 per share fair value estimate, Wong believes that this is a good entry point for long-term investors.