3 Warren Buffett tips on how to invest in banks

Investing in banks can expose investors to a lot of risk. The recent collapse of Silicon Valley Bank (SVB) is a reminder of how fragile these institutions are. So here are three of Warren Buffett’s best tips on how to pick the best bank stocks.

1. Demand a margin of safety

Banking is a risky business. High street banks tend to lend large amounts of customer deposits and profit from the interest earned on these loans. This means they are almost always in deficit.

Thus, if customers begin to withdraw funds en masse, banks may find it difficult to find liquidity, leading to what many call a liquidity crisis. This is what led to the failure of SVB and some regional competitors.

However, the failure was partly the result of irresponsible capital allocation. So, Warren Buffett’s advice on finding banks with a margin of safety is very important. The Oracle of Omaha believes that buying a stock is like buying a business, and doing your due diligence is essential.

Therefore, it is important to ensure that the company has sufficient liquidity and a strong financial set to withstand an economic crisis or a liquidity crisis. This can be evaluated through ratios such as CET1 (comparing the bank’s capital to its assets), liquidity coverage, and countercyclical ratios.

2. Look for economic moats

Most of Warren Buffett’s investments are in conglomerates with competitive advantages over their competitors. This is because companies that can successfully compete against competitors have a better chance of increasing their intrinsic value over time. This same precedent can be applied to banks.

The decline of several regional banks in the US led to a flight to quality. Consequently, happy with it JP Morgan and Bank of America has received tens of billions in customer deposits since SVB’s turmoil. This is what Warren Buffett would call the economic moat.

It is for this reason that UK banks stand out as the most attractive to me – strength and reliability. This is because a lower deposit base gives you a bigger buffer to protect yourself from a liquidity crisis.

This stems from the fact that the number of risk-weighted assets they hold is lower than their US counterparts. In addition, the number of retail customers they have is higher. Therefore, the probability of opening a bank is lower because the majority of funds are insured by regulatory bodies.

3. Focus on the long term

Another Warren Buffett tip is to focus on the returns that the bank can make over the long term. In the context of bank shares, it should produce a high interest income (the difference between the income generated by interest-bearing assets and liabilities) and a good return on real equity (ROTE).

However, there is a fine line between striving for big returns and potentially sinking your business into the ground. Being too greedy can cause bankers to take unnecessary risks, while being conservative can lead to low profits.

But thankfully, the British banks sit between the two, which is why I invested Lloyds. And given the low valuation multiple with a strong outlook for net interest income and ROTE for next year, I might start a position in Barclays.