Bill Ackman asked Warren Buffett about investing in financial companies at the 2005 Berkshire Hathaway Annual Meeting.
You would think with interest rates going up aggressively in 2022, that maybe it’s worth considering investing in bank or insurance stocks because you would think they should do well in this higher rate environment.
Bill Ackman of Pershing Square Capital Management asked Buffett, “Four of the handful of triple-A rated companies — AIG, Fannie Mae, Freddie Mac and MBIA — are under formal investigation for accounting shenanigans and are in the process of restating their financials. Like Charlie said before, I think of a AAA rated company as an exemplar — a company that should behave with the highest accounting and ethical standards. My questions this leads me to are, how can investors comfortably invest in any financial service company when a decent percentage of the triple-A rated companies have false and misleading financials? And the follow-up question is, why don’t the rating agencies do some independent due diligence from an accounting standpoint so that they can help serve as a watch on this issue?”
In short, how should we think about investing in bank and insurance stocks, for example? How can we truly understand them?
Buffett answered, “financial companies are more difficult to analyze than many companies,” saying for example that “insurance business, you know, the biggest single element that is very difficult to evaluate, even if you own the company, is the loss and loss adjustment expense reserve.”
When it comes to “a bank it basically is whether the loans are any good” and it’s much tougher to analyze financial institutions than a See’s Candy or a brick business per Buffett.
He further contended, “throw in derivatives on top of it, no one probably knows, perfectly, what some of the (or even within a reasonable range) the exact condition of some of the biggest banks in the world.”
You still never know what’s really under the covers of how complex the obligations might be with derivatives contracts, these financial complications could just be the tip of the iceberg of what else is lurking in a financial company’s records.
Buffett advises that we have to just “accept the fact that insurance, banking, finance companies [can be] both frauds and just big mistakes over time.”
Charlie Munger further added, “Warren is obviously correct that where you’ve got complexity, which by its very nature provides better opportunities to be mistaken and not have it come to notice, or to be fraudulent and have it not be found out, you’re going to get more fraud and mistakes than you are if you’re selling a business where you shovel sand out of the river and sell it by the truckload. And just as a business that sells natural gas is going to have more explosions than a business that sells sand, a business like these major financial institutions, by its nature, is going to have way more problems.”
Charlie summarizes the answer by saying, “so if you don’t like the lack of perfect accounting in financial institutions, you’re in the wrong world.”
In addition to definitely doing careful research and confirming that we think we truly can understand a financial stock. And IMHO, I also think some of this boils down to how much you think you can trust the management of the financial company.
With that logic, some people may have invested in companies like Berkshire Hathaway and Markel just because they trust Buffett and Munger, or in the latter case, Tom Gayner. And you knew that they are always acting in the best interests of shareholders.
If you were to see Berkshire investing in other bank and insurance companies, that could also be a hint as to what might be a potentially trustworthy financial stock. Nevertheless, we all have to do our homework before we make any investing decisions, especially when it comes to the complex world of financial institutions.
If you’re interested in learning how to take control of your finances and start becoming an investor like Warren Buffett, check out my free PDF guide.
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