Why Buffett Prefers Financial Stocks

At this time, self-made billionaire investor Warren Buffett is currently the fourth richest person in the world. He also has a very large following and is known for turning Berkshire Hathaway, a once struggling textile manufacturer, into a $300 billion mega corporation. He did it by investing in sound companies including Geico, American Express and Coca-Cola. Buffett is particularly fond of investing Berkshire Hathaway money into the financials.

Banking Stocks

It’s no coincidence that the largest Berkshire Hathaway holding is shares of Wells Fargo Bank. Berkshire Hathaway has owned shares of the company for just about two decades. After reviewing Wells Fargo annual reports, it’s quite clear as to why Warren Buffett enjoys owning this bank so much. The bank has the ability to receive cash from depositors and it does not have to pay any heavy interest on the money. The bank then has the opportunity to use this capital practically free of charge in order to make loans to creditworthy borrowers. Then they just profit from the spread.

The next major factor that helps Berkshire Hathaway’s bank investments in companies such as Bank of America and Wells Fargo is the customer relationships. If you choose to bank with Wells Fargo, you’ll most likely consider going to them when you need a loan to start a business, buy a house or purchase a new car. Additionally, you have exposure to the cross-selling of Wells Fargo credit card services and investment services.

Due to current United States regulations, Berkshire Hathaway is not allowed to purchase a bank outright. That’s why they are limited to having only a partial ownership interest. Regardless, these lessons should provide a solid model for investors as they think about adding banks to their portfolio.

Insurance Providers

Warren Buffett possesses a wide array of knowledge in the insurance business. Berkshire Hathaway purchased Western Insurance and Geico in the 1950s. Then in the late 1960s, the company acquired National Indemnity. Since then, they’ve continued to invest in insurance companies ever since. Buffett loves these companies because of their float. As Buffett quite elegantly tells us in his own 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 providers most often use this profit from the float as a way to invest in safe instruments like corporate and government bonds. If the insurance provider end’s up paying out fewer claims than the money that they receive in premiums, then this is what is called an underwriting profit. If the insurance company manages to maintain a breakeven point on insurance proceeds through a stable level of premium accounts, then it’s capable of setting itself up for a strong position to create higher rates of return.

Many insurance companies will continue to sell insurance even if they no longer feel well compensated for the risk. On the other hand, Berkshire Hathaway only does this when it is expecting to earn some money off of the insurance policies. Taking a potential future liability, without any proper compensation, could end up losing shareholder equity and money.

Insurance operation results can be lumpy, as well as bank operations too. Financial crises do happen. This will often lead to dividend cuts. But it seems obvious that financial stocks like Wells Fargo will continue to be great investments for long-term, patient shareholders with a long 30 year horizon.

Because financials are always going to exist even though there is obsolescence in most industries. Financials that have strong management, provide quality loans to creditworthy borrowers, increase customer relationships and billed recurring revenues are going to continue to see great success even with the short-term economic trouble. That’s why financial stocks are the lifeblood of any economy. They are an excellent investment to add to any portfolio.

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