How Warren Buffett and Thomas Brown Evaluate Bank Stocks

By Markets Fool.com

In the blue corner, we have Warren Buffett, the living legend, the Oracle of Omaha. In the red corner, we have Thomas Brown, manager of the financial-services-focused hedge fund, Second Curve Capital, and publisher of BankStocks.com.

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These two contenders are among the most successful bank-stock investors of our time. Buffett is the preeminent value investor extraordinaire, not afraid to pay a fair price for an amazing company. He's also ready to snatch up an asset on the cheap.

Brown flies farther under the radar, but still produces some exceptional results. He headed Tiger Management's North America Financial Services Group before starting Second Curve in 2000. Net of fees, the firm has returned more than 20% per year, on average.

Buffett and Brown are similar, and yet their strategies are very different. Let's compare and contrast.

More than one way to skin a cat
The first difference between these two money managers is driven not by philosophy, but by the practical reality of managing their respective funds. Buffett's Berkshire Hathaway is massive, and grows larger every quarter. The company generated cash flow from operations of more than $12 billion last quarter. To put all that money to work, Buffett must write really big checks to keep the company earning an acceptable return on capital.

Brown, on the other hand, runs a relatively small hedge fund with an estimated value of about $270 million, according to InsiderMonkey. When he invests, he need not limit himself to only the largest companies. Instead, he can write smaller checks to invest in smaller-cap stocks that are simply not worth Buffett's attention.

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The Buffett Method: Buy quality and hold it for a very long time
For a more detailed, metric-driven analysis of how Warren Buffett invests in bank stocks, click here. The long and short of it, though, is that Buffett makes big investments in banks that report high returns on assets and have historically performed well throughout the credit cycle. A few of Buffett's largest bank holdings demonstrate the point, as data from S&P Capital IQ shows us:

TTM ROA as of 9/30/2014
Wells Fargo 1.5%
US Bancorp 1.6%
M&T Bank 1.1%

Source: S&P Capital IQ.

This method works for a couple of reasons. First is Buffett's investment horizon. Anything can happen from quarter to quarter; even the best companies can hit a speed bump. However, over the long term, the very best companies will outperform.

Second, Buffett is exceptional at determining which stocks are the very best. He understands that Wells Fargo's deposit base gives it a competitive advantage in terms of funding that other banks can't match. He knows that US Bancorp is consistently one of the most efficient banks in the country. And he knows that those two facts are difference-makers.

Brown's method: Buy banks on the rebound
Tom Brown may know those facts, as well, but his tactics are a bit different. Brown's approach is more contrarian than Buffett's in that he seeks to find banks that have experienced credit losses or other problems which have driven their share prices down. Of those banks, he'll invest in the ones he believes have resolved those problems and are now on the upswing.

Brown also has the advantage of buying smaller-cap companies, as mentioned above. Currently, the largest holding of Brown's Second Curve Capital is a company with a market cap of just $581 million.

This small-cap strategy is not dissimilar to what is employed by another famed value investor, Joel Greenblatt. The fact of the matter is that smaller companies don't get the same attention from big-money investors and analysts. With fewer people examining the company, the likelihood is increased that the market will misprice the stock. That, in its essence, is how value investors make hay.

If Brown sees value in larger banks, he isn't afraid to jump in. Second Curve began building a relatively large position in Bank of America about 18 months ago. The fund has begun selling that position in recent quarters, selling 41% of the position between June 30 and September 31 of this year at a considerable profit.

Foolish takeway
Through comparing and contrasting these two investors, a couple of important lessons emerge. First, investors really can make money investing in banks. After the financial crisis, that may seem hard to believe, but it's true. These two gentlemen have been doing it for decades and continue to do so today.

Second, there's no singular, universal method to making money in bank stocks. For that matter, there is no universal method for analyzing any stock. Very smart people will have differences of opinions, and many times, both opinions could work well.

Third, to be successful in bank stocks, you have to work at it. Both Buffett and Brown focus a lot of time and energy on understanding exactly how these companies work, and what makes them tick. Brown has said of bank stocks: "The language and the accounting are different. It takes a familiarity that many portfolio managers may not have."

The lessons are not so different from our core philosophy here at the Motley Fool. Invest in great companies with relatively long investment horizons, and make sure you always do your homework. That way, you'll understand why the stock is likely to appreciate.

The article How Warren Buffett and Thomas Brown Evaluate Bank Stocks originally appeared on Fool.com.

Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends Bank of America, Berkshire Hathaway, and Wells Fargo. The Motley Fool owns shares of Bank of America, Berkshire Hathaway, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.