Berkshire Hathaway 2002 Annual Meeting Audience Question # 6

On banks trading at relatively lower P/E than the S&P

Warren Buffett:

Area 6?

Audience Member:

Hello. My name is Everett Puri. I’m from Atlanta.

I wanted to ask you to comment on the relative P/E multiples of bank stocks versus the S&P.

They seem to be at 30, 35 to 50-year year relative lows to the S&P, and I was wondering if that’s the result of the market… a change in the market’s perception of the forward growth rates of banks or if the market has perceived that there’s a change in risk there.

Warren Buffett:

You’re asking about the performance of what group compared to the S&P?

Audience Member:

Banks.

Warren Buffett:

Banks? Well, and what was your assertion about the performance, historically?

Audience Member:

Well…the relative multiple of bank stocks versus the S&P.

Back in the ’40s… ’40s, ’50s, ’60s, they commonly traded at, say, one times the S&P multiple and now they’re maybe half that level.

Warren Buffett:

Yeah. Harry Keith used to have a lot of figures on this.

I don’t really think about them. I mean, the appropriate multiple for a business, relative to the S&P, will depend on what you expect that business to achieve in terms of returns on equity, and incremental returns on incremental equity, versus that S&P.

I mean, if you’ve got two types of businesses, and we’ll say the S&P earns X on equity, and can deploy an additional amount of capital at Y, and then you compare that with any other business, and that’s how you determine which one is cheaper.

I would not characterize all banks as the same. I mean, we have in this room John Forlines, who runs the Bank of Granite… Granite, North Carolina… and they’ve earned 2 percent on assets without taking any real risks for decades. It’s a tremendous record.

And then you have other banks that have been run by people that took them right into the ground.

I mean, whether it was First Pennsylvania, going back 30 years ago, I think it was John Bunting, and they… they’re not a homogeneous group.

We own a couple of… stock… in a couple of banks. We own stock in M&T, that has an exhibit downstairs today. We own stock in Wells Fargo. And we think those institutions are somewhat different than other businesses.

So, I don’t think there’s… it goes back to that earlier question.

People always want a formula. You know, they… I mean, they go to the Intelligent Investor and they think, you know, somewhere they’re going to give me a little formula and then I can plug this in and I know I’ll make lots of money. And it really doesn’t work that way.

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, whether it comes from an internet company, or whether it comes from a brick company, the money 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.

And I would come to a very different answers, you know, on M&T Bank versus some other bank.

So, I wouldn’t want to have a single yardstick, or a, you know, relative P/E that I went by.

I think that banks have sold… a good many banks have sold… at very reasonable prices.

We bought all of a bank in 1969. We bought a bank in Rockford, Illinois.

Charlie and I went and looked… we must have looked at a half a dozen banks at that… you know, in a two or three-year period.

Charlie Munger:

Absolutely.

Warren Buffett:

Yeah. 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. And even Charlie and I can understand that. And low prices, incidentally, too.

And then they passed the Bank Holding Company Act in 1969, and they killed off our chances to do anything further in buying all of banks.

So, we look at banks. We will own bank stocks from time to time in the future. We’ll probably buy stocks in other banks.

We’ve also seen all kinds of banks ruined. I think it was, what was the fellow? M.A. Schapiro, who came up with the statement, he said, “There are more banks than bankers.”

And if you think about that a bit, you’ll see what I mean.

There have been… you know, there have been a lot of people that have run banks in a very injudicious manner, but that’s made for opportunities for other people.

A lot of banks have disappeared over time. I mean, up in Buffalo, where Bob Wilmers runs M&T, there were some other very prestigious institutions that went right down the tubes. And a lot of that happened in the early ’90s or late ’80s.

I wouldn’t look for a single metric like relative P/Es to determine what… how… to invest money.

You really want to look for things you understand, and 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.

And then, 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.

Charlie?

Charlie Munger:

Yeah, I think the questioner is, maybe, even asking the wrong people that question.

I would argue that Warren and I have failed to properly diagnose banking. I think we underestimated the general good results that would happen because we were so afraid of what non-bankers might do when they were in charge of banks.

Warren Buffett:

There are a number of banks, that over the last five or six years, on tangible net worth, the number net of goodwill, but on tangible net worth have earned over 20 percent on equity.

You would think that would be difficult for an industry to do 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…and you would think those kind of returns in a world of 6 percent long-term interest rates and much lower, you would think that would be very hard… well, you would have though it wouldn’t have occurred, you’d think it would be hard to sustain.

We been wrong in the sense that banks have earned a lot more money on tangible equity than Charlie and I would have thought possible.

Now, I think, to some extent, they’ve done because they stretched out equity much further than was the case 20 or 30 years ago.

I mean, 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, they’ve earned… 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… you know, the world compounds very fast.

You know, banking as a whole has earned at rates that are well beyond, on tangible equity, you know, well beyond, I think, what much more glamorous businesses have earned in recent years.

Charlie, you have any further thoughts on that?

Charlie Munger:

No, I say again, we didn’t diagnose it as it actually turned out and, even worse than that, we haven’t changed.

Warren Buffett:

And even worse than that, we won’t.

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