Why I Don’t Agree with Buffett’s Buy?

Recently, Warren Buffett (or his company, Berkshire Hathaway) bought more shares of Bank of America. In this post, I will discuss why I don’t agree with his buy and why you should care.

It is no secret that Buffett is a long time shareholder of Bank of America (BAC) since the 2008 crisis. In fact, he has been aggressively buying bank stocks such as JP Morgan, Goldman Sach and US Bancorp.

However, this additional purchase of BAC shares was more significant, because his company now owns more than 10% of BAC total shares. This will make him a significant shareholder which requires the company to file a lot of paperwork and seek approval from the regulators.

Disclaimer

Before I explain why I don’t agree with his latest buy, I want to state that I DO NOT think I am better than Buffett. Rather, I think it is important to always check my investment thesis, even if it is from my role model like Buffett.

How Do Banks Make Money?

In simple terms, banks make money by borrowing and lending money, and earning the difference.

For example, if a bank can borrow money at 2% interest rate, and lend it out at 4%. It will make the 2% difference.

Hence, you will notice that when the bank borrows money from you, such as when you put money into bank savings or fixed deposits. The interest that you receive is always less than what the bank charges you for taking a bank loan such as mortgage loan, student loan.

What is the Main Factor Here?

One big factor in this banking game is short term interest rate which is determined by the central banks. As we discussed before, interest rate is very low now, just over 2% after the most recent cut, with talks about further cuts to come.

How Does This Affect The Bank?

Firstly, when the bank borrows money from you (such as fixed deposit or pure savings), you expect some interest in return, but there is a bottom limit to how little interest you are willing to accept.

For example, the current fixed deposit interest rate in Singapore is around 1.7% per annum. If the banks were to lower it further, savers might not put their money with the banks as it won’t not be worthwhile anymore. Or as my mum would say,

“Might as well keep it under the pillow”

My mum

However, in a low interest rate environment, banks are unable to charge a much higher interest rate when issuing loans too.

For example, the current mortgage loan in Singapore has an interest rate of around 2.08%

This means, in this example, the banks are only earning a difference of 2.08% – 1.7% = 0.38%

A Catch-22 Situation.

They can’t borrow at a low enough rate and yet they can’t lend money at a high enough rate either.

This would normally be offset by larger volume of bank lending money since it is cheaper for us to borrow from the bank.

However, we are already in a low interest rate environment before the most recent cut! The interest rate fell from 2.25% to 2%. Unlike in the past when interest rate were as high as 6-7%.

What does this mean?

This mean the recent interest rate cut is unlikely to stimulate any significant increase borrowing from the banks, as the difference in cost of borrowing is too little and any borrowing would have already taken place during the past interest rate cuts.

This means the banks’ profit margin is likely to be squeezed by the recent interest rate cuts and it doesn’t look like we can expect interest hikes any time soon.

Is This Analysis Too Simplistic?

My analysis may be too simplistic, especially if you are from the banking sector. However, I came to my own conclusion after speaking with several colleagues in banks.

Don’t invest in anything you can’t explain with a pen and paper.

Peter Lynch

To me, while there can be grand theories about how banks will still be profitable in any environment, I prefer to listen to the troops on the ground because they are the ones experiencing the impact in their daily lives.

Therefore, I don’t quite agree with Buffett’s latest purchase of bank stocks. But of course, I could be terribly wrong too.

He is Warren Buffett, afterall.