About a month ago, I was trying to rebalance my portfolio toward lower risk and less focus on higher Beta stocks. I was thrilled that my equity screens showed the best opportunity in banks matched recent purchases by Warren Buffet in Berkshire Hathaway’s portfolio. My screens showed Bank of America and US Bank as the top picks driven by higher economic profit, product innovation, lower debt-leverage to other bank peers, and higher cash-flow to market capitalization. Warren also added JPM/Chase but it is a small position of $3.8 Billion and only 1.1% of JPM capitalization. I admire and respect Warren Buffet, so I felt good that my risk-return screens were close to what Warren just bought.
I reviewed the balance sheet of Berkshire Hathaway’s two largest holdings, Bank of America and Wells Fargo, representing a market capitalization of $23.9 Billion and $23.1 Billion, respectively, as of September 30, 2018. What struck me is that these two banks look so similar in asset mix with commercial loans higher than consumer loans. I soon verified that almost all banks have an average earnings yield of under 4% (U.S. Securities and Exchange Commission). Given the large amount of corporate loans on banks’ balance sheets (e.g. Bank of America and Wells Fargo both have approximately $500 Billion as of September 30th, 2018), I was very surprised by the low yields (Bank of American at 3.89% and Wells Fargo at 4.24%). If the next recession is a commercial recession, it could be deep and long (Franck, 2018).
Clearly, the banks have been buying yield above a very low cost of funding. In my last Blog, I make the case that government debt is going to drive much higher yields with no credit risk and crowding out the corporate and consumer debt markets (Cox, 2018). I still expect long interest rates to rise because of high US debt levels. Most investment managers disagree with my view because the yield curve is inverting and the 10-year Treasury is down to only 2.8%, so there are no signs of Treasury rates going higher. However, I see the decline in 10-year Treasury rates as temporary. Hedge funds are unwinding their shorts on long duration fixed income assets and selling long equity positions. I did buy some bank stocks because a reasonable percentage of assets are variable rate, but shorted Berkshire Hathaway as a hedge. Why?
One can argue that the banks will be stuck holding low-yielding assets and will ride them into an approaching recession accelerated by the stock market decline and rising long term rates. Now if you own Berkshire Hathaway stock be careful. Here are some risk signs:
- Berkshire has 40% ($85 Billion) of their total equity exposure in bank stocks, when a risk-balanced portfolio should only have a 14% weighting. (Bary, 2018)
- Berkshire added $24 Billion in equity exposure in 2018 versus adding only $4 Billion in 2017. The returns in 2017 were very positive but 2018 stock returns are mostly losses.
- Berkshire has done stock buybacks this year even though the market capitalization of Berkshire is higher than book value, which used to be their risk appetite policy.
- Berkshire Hathaway represents 13.31% in the XLF ETF for financial institution exposure, which is by far the largest position. Every decline in the XLF price will impact BRK/B proportionally. XLF is near bear market territory as of Nov 22, 2018.
- Berkshire added Apple stock in 2018 and had $38 Billion of exposure as of September 30th. Berkshire is loaded with transportation shares and value equities that have been going down since October of 2018. (“Berkshire Hathaway Portfolio Tracker,” 2018)
- The new financial reporting of BRK/B will now show the market price change of the underlying holdings, so expect the December 2018 quarter end to show dramatic equity price decline, especially driven by large declines in Apple and the bank stocks.
- Everybody is a long-term holder of BRK/B because they love and trust Warren Buffet. Should you hold the stock you love in a bear market when the underlying stocks have such bad momentum?
Are you a lover of bank stocks given that their cash is trapped in low yielding assets and there are so many factors in 2019 that could exacerbate a quick recession?
Bary, A. (2018, November 26). Why Warren Buffett Has Gone Big on Big Banks. Barron’s, p. 17.
Berkshire Hathaway Portfolio Tracker. (2018, November 15). Retrieved December 23, 2018, from https://www.cnbc.com/berkshire-hathaway-portfolio/
Cox, J. (2018, November 21). A $9 trillion corporate debt bomb is ‘bubbling’ in the US economy. Retrieved December 23, 2018, from https://www.cnbc.com/2018/11/21/theres-a-9-trillion-corporate-debt-bomb-bubbling-in-the-us-economy.html
Franck, T. (2018, December 11). Former Fed Chair Yellen says excessive corporate debt could prolong a downturn. Retrieved December 23, 2018, from https://www.cnbc.com/2018/ 12/11/janet-yellen-says-excessive-corporate-debt-could-prolong-a-downturn.html
U.S. Securities and Exchange Commission. (n.d.). EDGAR | Company Filings. Retrieved December 23, 2018, from https://www.sec.gov/edgar/searchedgar/companysearch.html