I’ll post more thoughts when I have time.

Admittedly, banks are tough for me to value. My view on their loan purchases as CapEx is the same as Ford. Ford doesn’t need to build new plants or upgrade equipment – they can invest their cash in treasuries as well. But that will only get them so far.

You said, “You can bring in deposits easy by just increasing the rates you pay.” But how do banks get those higher rates? They have to acquire loans that will pay enough interest so that the bank can take their spread and give the higher rate back to the depositor.

How would a small bank make money if it didn’t loan out deposits (or acquire loans with deposits)? Investing in treasuries will likely hinder their growth. In the same way, Ford can keep pumping out vehicles on their old equipment, but the quality will continuously decline and their customer base will dry up.

Then again, this is outside my sphere of competence so this discussion is all in the interest of learning (for me, at least). You said something interesting: “The reason they make loans to for the benefit of their shareholders and not the depositors.”

If I am going to be a shareholder in US Bank, and US Bank has to buy these loans to increase owner earnings and grow, I would consider those loans to be mandatory in the ordinary course of business – a cost of doing business, and a charge to owner earnings because the company has to spend that cash. Though not technically a capital expenditure, I would consider it as such for the purposes of calculating owner earnings and the business’ value.

My two cents on it.

Banks do not have to make loans. They could simply buy securities/treasuries with depositors money and go along with their business. The reason they make loans to for the benefit of their shareholders and not the depositors. Rates on the savings accounts are driven by the loan demand and not the other way around. I think this is where you are going wrong in your assumption. CDs and savings accounts are funding lines. You can bring in deposits easy by just increasing the rates you pay. It is the no interest deposits that bank’s mouths wet over and in that case you are paying nothing to the depositor.

It is easy to get lost in the numbers but I encourage you to look at the numbers of some smaller banking institutions. I think you will find where loan demand is low banks pay near nothing for deposits and have a large security portfolio or participation/syndicate loan portfolio. Buying and selling loans is an investment strategy that is necessary in the banks but should not be classified as capital expense. They certainly are not necessaties but more so a path to higher returns for their shareholders in my opinion.

Expanding on the post above, if U.S. Bank didn’t buy and sell loans, it wouldn’t generate the interest it needs to pay depositors. If it can pay depositors, it can’t keep its clients. As such, I consider loan acquisitions and sales as crucial to U.S. Bank as factories are to Ford.

Though CapEx is traditionally “Plant, Property & Equipment,” that is an IRS rule, not a business owner rule. To business owners, a CapEx is anything that the business must buy and use to maintain (or grow) its operations, but can’t (or shouldn’t) expense in earnings. For many financial services companies, that includes investments and loans that are necessities, not luxuries.

Make sense?

Thanks Joe!

If this were a publicly traded company, I’d tell you to RUN! F Wall Street generates negative owner earnings as I personally pay all the costs and don’t pump it full of ads. ☺ I hope I can keep it that way; then again, there is a certain something to being CEO of NYSE listed FWS (the ticker is available!)

1) Financial firms are too hard for me. Buffett has always marvelled at banks, however, because moat is virtually a non-issue. Once people start with a bank, it is like pulling teeth to get them to switch and the market is never really oversaturated. When I get back from (or while on) vacation, I’ll take a more in-depth look at Wells Fargo.

2) Builders are tough to value. They have huge capital outlays to start, are highly sensitive to interest rate fluctuations, and have considerable freedom in how they value and report their assets. Who really knows what a home built from raw land is worth until it is sold? Sure, they can speculate, but where does that put us?

If home builders and real estate are in your sphere of confidence and competence, by all means take a look. The valuation is always the same: How much cash can be taken out of the business during its remaining life. Answer that…and you’ll find your bargains.

Hope that helps!

Two questions though –

1. Agree Financial stocks often fall into the “Too Tough” category, but what makes Wells Fargo different from the others, in your opinion? What do you see in their financials that makes Buffet like this over all other Banks and Financial Services Firms?

2. Any idea about how to value Commercial or Home residential builders ( Like KB Home, Hovnanian etc? ) . Particularly any red flags or key items to be sensitive to?

Many sell side reports tout the low ( even less than 1 ) price to book ratios of these companies, stating that they are now selling at “below replacement cost”, but these companies could always continue to mark down the real estate holdings and thus book values ( or worse still, not take these charges and keep us in the dark). How would you go about valuing these firms? Certainly they have been beaten down quite a bit and might offer potential bargains to the keen investor.

Thanks again for your great posts and stellar website. Jay

I haven’t seen a simple, no-brainer bank/financial services company yet; but, there are plenty of companies that are simple and grow steadily. The universe of these companies is small, and they are rarely underpriced. That’s exactly why we need to be patient and wait for the great opportunities.

The “simple, no-brainer” concept applies to all stocks, not just financial services. Adobe Systems – simple (to me), no-brainer (to me), but fairly valued. I have to wait for the market to beat Adobe to the ground before I can buy it. Will I miss some growth? Probably. But I don’t want growth…I want super growth with little to no risk.

Keep turning over the rocks. Eventually a company will jump out at you. Those are the ones you want to put your money in.

It is schooner, a type of beer mug.

I’m going to knock back a Guinness or two this evening.

Again, many, many thanks for all the knowledge you are providing here. I can’t wait to purchase your book.

Have a great weekend.