Banking Lessons from Buffett

Recent events in the financial markets have taken a heavy toll on the stock prices of many banks, with many such stocks trading at multiyear lows. However, not all financial institutions are created equal, as shareholders of Bear Stearns and  Countrywide Financial  learned in recent months. With that in mind, we looked to  Berkshire Hathaway's (BRK.B) Warren Buffett for help in separating the wheat from the chaff.

"The banking business is no favorite of ours," Buffett wrote in his 1990 letter to Berkshire Hathaway shareholders. "When assets are twenty times equity--a common ratio in this industry--mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks." While Buffett was referring to the S&L crisis at the time, he could easily have been discussing the current problems in the mortgage market.

Buffett's warnings on the dangers of leverage are similarly timeless. When buying a debt-free business, a 10% error in calculating the fair value of the enterprise is well within the margin of safety included in our 5-star price. But a similar error in valuing a highly leveraged financial institution could be the difference between investing in a bargain and a bankruptcy. When assets exceed 30 times equity--as in the case of investment banks  Morgan Stanley (MS) and  Lehman Brothers --the margin for error is even smaller. For this reason, we believe Morningstar's fair value uncertainty rating is especially important when evaluating a potential investment in a financial company. The lower a stock's uncertainty rating, the more confidence an analyst has in the accuracy of the stock's fair value estimate.

Buffett also emphasized the importance of management. "Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a 'cheap' price. Instead, our only interest is in buying into well-managed banks at fair prices," he wrote. Buffett was buying  Wells Fargo (WFC) at the time, a bank that still receives our highest Stewardship Grade. Other banks in the Berkshire portfolio include  M&T Bank (MTB),  U.S. Bancorp (USB), and  Bank of America (BAC)--all of which receive high marks for stewardship from Morningstar analysts. While the quality of management is important in all businesses, it is especially important in banking, where a relatively small mistake by a CEO can lead to disaster for shareholders.

Buffett went on to explain an additional risk in the banking business: that of the "institutional imperative--the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so." Almost 20 years later, Buffett's words still ring true. Few financial institutions managed to resist the temptation to jump headlong into subprime mortgages, CDOs, and other questionable products. Banks that loaded up on home equity and construction loans during the housing boom are also now suffering the consequences. Again, Buffett's writings proved prescient: "In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate." Managers of some of the country's largest financial institutions indeed experienced this fate in the past year, including Chuck Prince of  Citigroup (C), Stan O'Neal of  Merrill Lynch , and most recently, Ken Thompson of  Wachovia .

Taking Buffett's advice into account, we used Morningstar's  Premium Stock Screener tool to search for other banks that might meet his criteria. We looked for regional banks with low Uncertainty Ratings, Stewardship Grades of B or better, and Morningstar Ratings of 4 or 5 stars. Not surprisingly, only a few stocks met this lofty set of criteria:

Our List of Well-Managed Banks at Fair Prices
Company	Stewardship Grade	Uncertainty Rating	Star Rating
City National Corporation	B	Low
First Midwest Bancorp	B	Low
M&T Bank Corporation (MTB)	A	Low
Trustmark Corporation (TRMK)	A	Low

We believe the companies on this list are indeed "well-managed banks at fair prices," and we think investors would do well to purchase shares of any of these institutions at a reasonable discount to our fair value estimate. In our opinion, investing in shares of these banks will allow shareholders to sleep well at night, while enjoying returns that could make Buffett himself envious.

Morningstar.com Premium Members can run this screen themselves by  clicking here. Not a Premium Member? You can still run this screen by taking a free, 14-day Premium Membership trial. (Note that the results may change as stocks come in or drop out of the screen over time.)