Would you be able to give us an example of a bank for your analysis?

Thanks,

Kevin

Thanks,

Malcolm

I think I have just been spared a lot of futile “homework” trying to get my head around a rational view on banks.

A recent study claims to prove that simply following Berkshire Hathaway`s picks after they are made public would result in a return nearly as good as Berkshire itself:-(http://www.cnbc.com/id/21834492/)

Assuming that this report is not totally flawed, one may, as one post already suggests, just opt to follow Buffet on the Banks issue.

It’s comforting to observe that Berkshire’s financial picks appear to be in free fall (along with the rest) increasing the MOS for lesser mortals day by day. Technical analysis may be the pits, but watching for the free fall to stop (or at least pause) would seem the only rational course of action for anyone wishing to put their nerves to the test.

Either there’s a bottom to the slide, or the entire global economy is rapidly going pear shaped.

The issue of a global melt down is, of course, just as relevant to all other investments in stocks and not just a headache for would be dabblers in Financials!

Given the difficulties with valuing financial firms (outlined by Graham and Dodd), you would expect that Buffett, either, holds the same view or has hit on a superior method since working for Graham in the 1930s. This second interpretation would make sense, given BH’s insurance holdings and the Wells Fargo investment, but Buffett has readily admitted to error when it comes to super cat insurance exposure related to 9/11 and Katrina, in addition to the Soloman experience described by Nick. Regardless, Wells Fargo is reported to have significant exposure to sub-prime and alt-A loans. There is, certainly, little in the statements of an average financial firm to provide even the most precise investor with prior warning about the quality, risk, or focus of sub-prime, alt-A, derivatives, SIVs, etc.. Besides, even if Buffett believes he has found a superior method for valuing such firms (and has not described it publicly), it still exceeds my comfort zone and goes into the “Too Hard” basket.

This doesn’t mean that I’m not open to being educated by those for whom this isn’t “too hard.” I’d love to know how the average investor can value the benefits and risks associated with derivatives, sub-prime loans, and, of course, the less exotic, but largely hidden, investments commonly made by financial institutions. It seems clear that the rating agencies are not a capable or reliable source for this information, since they were rating many CDOs as AAA until recently. Their excuse is that such investment instruments are new and lack a sufficient history on which to actuarially calculate the risk of default or decline. Buffett is smart, but, by his own admission, he is no smarter than the most competent of Wall Streeters. According to him, his advantage is his fealty to a rather simple philosophy of investing, learned through experience and at the feet of giants, such as Benjamin Graham, David Dodd, John Burr Williams, Philip Fisher, and, more recently, Charlie Munger. It is this relative simplicity that makes his approach available to you and me.

John Holland of the Santa Fe Institute is one of the founding fathers of artificial intelligence (specifically, neural networks, as opposed to genetic algorithms). It is from this that programmatic or rule-based trading evolved. Even if we discount this approach as increasing risk beyond prudent tolerance and believe that AI-based investing truly represents the best approach, it would be too complex for the individual investor and, until recently, beyond the computing power of the home PC. As such, it might be a superior approach but lack any utility for the small investors who frequent Joe’s excellent blog. The same logic may, in fact, be true of valuing financial firms — i.e., possible for the likes of Buffett but not easily accomplished by those “playing at home.” This might explain why he has not described his approach in the chairman’s letters, but that conclusion would be nothing more than supposition on my part.

Joe, this would be interesting question for your friend Mohnish to pose at the next BH stockholder’s meeting.

Any ideas?

Great stuff. This is one of my favorite sites and thanks for keeping this up Joe.

Jay

Also, Buffett may be good a valuing financial firms, but he hasn’t shown it. The only financial house that he’s owned, to my knowledge, was Salomon back in the 80′s, and he even said after he liquidated his position that it was an attractive security (preferred) in an industry that he normallly wouldn’t touch. Plus, he was familiar with most of the executive team, so he felt he could rely on them.

Even Buffett doesn’t touch financial companies. He tends to stick to insurance, which seems to be less far from most people’s “too hard” pile.

Keep it simple. That’s a reiterative statement for a reason.

Nevertheless, it is at the due diligence stage that problems arise. The strength of a bank (regardless of its exposure to sub-prime) is only as good as its holdings. Where the diligent investor can analyze conglomerates, like GE, by considering its portfolio of products and services individually, this is rarely possible for financial firms. The on-going melt down of financial stocks, while linked to sub-prime, is actually attributable to a lack of clarity — the very complaint voiced by Benjamin Graham in the 1930s AND by Benjamin Bernanke earlier this week.

None of this should suggest that your investment is in jeopardy or ill-considered. It may be a great selection (probably is), but it is beyond my scope of expertise and comfort for all of the reasons proffered above. If you are comfortable valuing banks and the effort falls within your realm of expertise, you have my admiration, envy, and best wishes. For those who lack this level of comfort, the message of the post is simple. “You are in abundant good company.”