Motley Fool Hidden Gems Investing - Banks, Banks, Banks

Episode Date: October 15, 2024

When you are the custodian of almost $10 trillion, how much more can you possibly grow? Motley Fool Contributor Matt Frankel joins Ricky Mulvey for a look at bank earnings. They discuss: - Why Charles Schwab is welcoming a rate cutting cycle. - Goldman Sachs’s biggest red flag. - Bank of America CEO Brian Moynihan’s outlook on the American economy. Then, (14:29) Motley Fool Senior Analyst, Buck Hartzell joins Alison Southwick and Robert Brokamp to kick-off a series on Berkshire Hathaway, and how the conglomerate’s collection of businesses work together. Vote for Motley Fool Money in the 2024 Signal Awards for Best Money and Finance podcast: https://vote.signalaward.com/PublicVoting#/2024/shows/general/money-finance Companies discussed: SCHW, GS, BAC, BRK.A, BRK.B Host: Ricky Mulvey Guests: Matt Frankel, Alison Southwick, Robert Brokamp, Buck Hartzell Producer: Mary Long Engineers: Tim Sparks, Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

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Whatever lies ahead, don't change your morning. Let your morning change you. Discover Coffee Plus on Nespresso.com. We've got big themes from big bank earnings. You're listening to Motley Fool Money. I'm Ricky Mulvey, joined today by Matt Frankel. Matt, appreciate you being here. Thanks. It's been like twice in a week. I'm really glad to be here again. Well, when we got you, you're a bank watcher and we've got a lot of big banks to watch. We're getting a macro picture is a lot of the big banks have kicked off this earnings season.

This is the first time we're getting their insight into this new rate cutting era. Seems to be a little bit of a low interest rate party going on. But what is your headline from the pile up of big bank earnings? Better than expected, but that's usually the headline every quarter. I don't know who these bank analysts are. They're obviously not very good at realistic estimates. I feel like they always kind of set the bar a little bit low and banks tend to over deliver. But it is worth mentioning that the rate cut that you're talking about, yes, the banks are all trying to talk it up, but it's really not reflected in the numbers yet because it just happened toward the end of the third quarter.

So take that as you will. Not the deal making, not the debt pay down. Let's start with Charles Schwab and add some context to this because Charles Schwab had a good quarter, investors responding positively to it. But let's take it back a few years ago for the bank slash brokerage slash wealth manager. When the Fed was raising interest rates, this created a problem because Schwab's customers were moving savings in low interest paying accounts over to investments like bonds that paid interests, money market funds, that sort of thing.

So we'll start a couple of years ago before bringing it to today. Why was that shift a problem for Schwab? Yeah. Schwab has to keep a certain amount of assets on its balance sheet. Just to give you some context, the average rate that Schwab pays on customer deposits, like cash sweep and things like that, is about 1.3% on borrowings, meaning if it needs to borrow money from another bank, if it needs to issue high-yield products like CDs to its own customers, things like that, the interest rates they're paying are about 5.5%. So, the higher the interest rate they're paying, the lower their net interest margin is going

to be. But the problem they ran into was, with people shifting into higher-yielding assets, as you mentioned, like treasuries and things like that, was they didn't have enough money on the balance sheet. And that's a big, big problem for banks. You probably heard that banks need to maintain certain capital ratios. They have to submit the stress tests every year, things like that. And it kind of brought Schwab's balance sheet in the wrong direction.

So I've been a Schwab shareholder for a little bit in part because I thought that the bearishness on a company that owns or not owns, but has custody of trillions of dollars in assets might have a tough time tipping over. And we saw that strength continuing into this quarter where total client assets reached almost $10 trillion and about $250 billion of that. A quarter trillion was new for the year. Revenue was up 5%, but they saw net income rise 25%, 5X what we're seeing there, to $1.4 billion. And also, active brokerage accounts continuing to climb even after the TD Ameritrade merger.

There's now 36 million active brokerage accounts on Schwab. That's up 4%. Anything in the big numbers stand out to you here? Well, one, Schwab's doing a whole lot better of monetizing its platform. It's been leaning into things like, I mentioned bank CDs, they're leaning into loans, they're leaning into financial advice. The managed investing solutions saw $40 billion of net inflows this year. Those are things like where people pay Schwab a percentage of their assets to manage money for them. Kind of like an old school investment manager, but for a much lower rate. And they're doing a great job of attracting that. I actually think my own father just signed

to sign up as a Schwab-managed investing client. They're doing a great job of leaning into their better monetized products. You're right. A lot of the client asset increase to almost $10 trillion, a lot of it was new money flowing in, which is impressive. The bulk of it is because the stock market's doing so well. If you have $10 trillion in assets and the stock market rises by 20%, you're going to have $12 trillion of assets. But they are still attracting new money. And to be fair, people do like to put money into the market when it's doing well, which it is. After the TD Ameritrade acquisition, I thought they were going to have a tougher time retaining those clients. Investors generally don't like change as much as you might think they would.

So moving to a new platform and things like that is often a reason that you see people kind of abandon ship and look for what else is out there. But we haven't seen that nearly as much as a lot of people expected. Just people complaining about the Schwab user interface, but they're not going anywhere. I'm one of them. I still have my account. One of the key items, and this goes back to two years ago, is that cash sweep, which was a problem. That grew by about $9 billion for Schwab. And it also helped them reduce something called bank supplemental funding. I know we're getting technical here, but this is a big deal for Schwab because this is what a lot of investors are paying attention to.

So let's focus on that term first. What is bank supplemental funding and why is Schwab concerned about it? Yeah, so this is something all banks deal with. One of my favorites to watch is SoFi, and they have been dealing with this too. Bank supplemental funding. Basically, banks need to bring in money, and they need enough money to cover all of their loans and things like that. The best way to do it without getting too technical is through low-cost deposits. I mentioned earlier, Schwab pays an average of about 1.3% interest on the deposits from its customers. That's the kind of funding it wants, to be able to loan to other customers

and to be able to shore up its balance sheet. Bank supplemental funding refers to money it borrows from other banks or borrows from its own customers in the form of CDs. That's also considered bank supplemental funding. That carries an average interest rate of about 5.5%. The more of their capital that they're paying 5.5% on and not the 1.3% on, the worse it is for their net interest margin. That's why it was such a concern.

And that's why it's such a good thing to see that number dwindling. And they borrow money from Federal Home Loan Bank. That's their biggest banking partner. That's down from about $36 billion a year ago to less than $23 billion now, just that component of it. So that's really moving in the right direction. So Schwab getting some trading action, Schwab paying down its debt, also some personnel change.

Walt Bettinger is stepping down as the CEO. He led the company since 2008. Any reflections on his tenure at Charles Schwab? I mean, he turned them into a powerhouse. There's no other way to say it. They're the clear number one broker in the United States right now. And that was not the case when he took over as CEO in 2008. He's not leaving entirely. He's staying on as executive co-chairman. To be clear, the other one is Charles Schwab. So there's going to be two himself, the co-founder. There's going to be two executive co-chairmen, the two pretty much heavyweights. His second-in-command president,

Rick Worcester is going to be taking over. He was formerly head of Schwab Asset Management, so he knows the business really well. He's been groomed for this role for a long time. He is expected to continue what they're doing right now, like I mentioned, leaning into the more profitable areas of the business, like the actively managed accounts, like the lending business, things like that. If he can continue to do that, I don't know how much bigger Schwab can get, there's an upper limit on how much more assets they're going to attract. I think he's going to be a good leader. Literally, you got $10 trillion. How much money is left in the world to get under your custody? Let's move on to Goldman Sachs, another big bank that appears

to be doing just fine. Pre-tax earnings for the bank rose 45% from one year ago. That's a lot for a mature company. Where's that profit coming from? A few places. The environment is actually really strong for investment banks in particular right now. The environment's expected to get strong for consumer banks, which we'll get to in a minute with Bank of America. But right now is actually a really strong time for investment banking, and for a few reasons. One, more companies are going public in the stronger market environment. You're seeing the return of the IPO, essentially, after a pretty long drought. You're seeing more companies being willing to issue debt. This is the interest rate cut you were talking about. Companies are more willing to issue debt,

which you need an underwriter for that debt. That's where Goldman Sachs comes in. More IPOs, more secondary share offerings. The market environment has been strong, but volatile a little bit. That's a strong environment for trading revenue as well. We saw Goldman Sachs destroyed expectations on trading revenue, about half a billion dollars more than expected, up 18% year over year. And not only that, Goldman Sachs is one of the biggest asset managers in the world. They have over $3 trillion of assets under supervision. That was up 16% year over year, mainly on strong market performance, but there were inflows. And that is a larger pool of assets they can generate fee income from. So it's really like the environment's helping investment banks

on all sides of the business. People like to invest when equity values go up and you're seeing that investment banking revenue rise 20% from a year ago. JP Morgan Chase and Bank of America are also seeing their investment bankers get busy. A lot in Citigroup, they had more than a 40% increase in investment banking revenue is that deal-making is going on that you talked about. I want to focus to the consumer side, which is where Goldman is admitting that it made a mistake. It's trying to exit the credit card business, trying to walk back some of its plans it made in the consumer finance area. Goldman ending a credit card partnership with General Motors. That business moves to Barclays and will cost $400 million. However, Goldman

still has about $17 billion in credit card balances with its Apple partnership. Goldman's great at investment banking. It's good at high net worth individuals. Why do you think it's run into trouble with the consumer banking and finance area? Honestly, I think it's poor execution. The consumer banking debacle is my biggest red flag with Goldman Sachs. The fact that you say, OK, we're going to go head on into the credit card business, and then you land a whale like the Apple Card, and you can't make it work. I don't know how much better of a credit card product you could have thrown in your lap. I know they made a bad deal is really the problem there.

But the fact that you can't leverage that brand name, Goldman Sachs has the very rare combination of arguably the most recognizable name in the financial services industry, and they don't have a big branch infrastructure that costs a lot of money and things like that, the fact that you can leverage that combination to do things like consumer savings accounts and really just build a consumer business is kind of a red flag for me. But at the same time, there's no denying that they're really, really good at investment banking, And there seems to be a lot of upside potential there. But yeah, I'm glad that they're winding it down.

They did admit they made a mistake fairly quickly. So that's the biggest positive I can see out of that. For most of the listeners who are not watching this, Matt Frankel offering a shrug emoji with the exit of the consumer finance area and the refocus back onto the investment bank side. Let's wrap up with Bank of America, Brian Moynihan offering a view of the macro environment, basically saying that the consumers are healthy. Look at them. They're spending more money. It's provision for credit losses. He is saying essentially unchanged,

only using the quarter over quarter number, not the year over year number. And on the consumer payment side saying this activity is consistent with how customers are spending money in the 2016 to 2019 timeframe when the economy was growing and inflation was under control. Do you agree with CEO Brian Moynihan's rosy picture of the American economy? Well, I will tell you that consumers willingly spending money and healthy financial behavior are not always the same thing. We saw this in the lead up to the financial crisis about 15 years ago when people were very willing to spend money on buying houses and things like that. But that doesn't make me... It was very healthy financial behavior. But having said that,

It looks like we're at, I don't want to say an inflection point, but it looks like in a lot of ways, the consumer is healthier than expected. We've seen loan losses tick up. The charge-off rates, we've seen them tick upward over the past couple of years as we came out of the pandemic shutdowns when they were very, very low. Now they are above pre-pandemic levels, but it looks like things are leveling off. I don't know if I'd call the consumer very strong, very willing to spend, for sure. Maybe the consumer has a positive outlook on the economy. As you and I talked before we recorded this, loan losses are still somewhat elevated over the past year. The loan loss provision they're setting aside, which has flattened sequentially, quarter over quarter,

but it's still significantly higher than it was a year ago. That tells me that the consumer isn't getting less healthy, is the best way I could put it. Matt Frankel, appreciate your time and your insight. Taking a look at the big banks as they kick off this year's earnings season. Thanks for having me. All right. Before our next segment, a quick plug. Motley Fool Money is currently a finalist for Signal's Best Money in Finance podcast for 2024. We're up against some big dogs at Barron's The Financial Times in Bloomberg, and the winner is determined by your vote. So if you like the show, all of us here at Motley Fool Money would appreciate it if you

take a moment and cast your vote for us. There's going to be a link to the contest in today's show notes. Now, up next, Motley Fool senior analyst Buck Hartzell joins Alison Southwick and Robert Brokamp to kick off a three-part series on Berkshire Hathaway and discuss how a small textile company grew into a behemoth that now owns more treasuries than the Federal Reserve. Warren Buffett is famous for being the greatest investor, businessman, and philanthropist of our time, or maybe ever. Through his company, Berkshire Hathaway, he's grown his own wealth to roughly $144 billion and in the process made many long-term shareholders extremely wealthy. He's also given away $55 billion in that time. But what does Berkshire Hathaway actually do

and how? And maybe also when, where, and why? That's what we're going to discuss with the help of Motley Fool analyst and longtime Berkshire Hathaway shareholder, Buck Hartzell. Hi, Buck, how you doing? Hi, Allison. And hi, Robert. Thanks for having me today. I appreciate it. Yes, we also have Robert Brokamp here as well, who is also a Berkshire Hathaway longtime shareholder. It is. I think it's my number one stock these days. Oh, very nice. So, Buck, let's start with you, though. How long have you actually held shares of Berkshire Hathaway? I think you've been to a number of their annual shareholder meetings. I need you to just express for me fully your love of this company yeah i think i've owned berkshire

since the late 1990s i i believe the first um annual meeting i went to was in 2000 um so and i i've been to a variety not all of the meetings since then but i have had uh my wife has been there and all three of the hartzell children have been to a berkshire hathaway um annual meeting they are card carrying capitalists uh so they have their card to support that and so i've been to a decent amount of the Berkshire annual meetings over the years. And I think there's a lot of things that are unique about Berkshire that separate them that can be summarized and felt and experienced if you go to the annual meeting. So I'd encourage everyone to do that while they have a chance. And the one thing I'd say is a partnership model, right? Warren Buffett

started out with a partnership. It merged into another company and it grew into Berkshire Hathaway and what we have today. But one thing that has remained the same is that he treats all of his shareholders as partners in the business. He communicates to them the way he'd like to be communicated. And he's also shared a lifetime's worth of investing lessons that he didn't need to over the course of those years. So it's a wonderful company that's built on a web of trust. All right. Perhaps not surprisingly, Berkshire Hathaway is a reflection of Buffett, at times very boring and at other times a little bit eccentric. So we should probably start with some history of Berkshire Hathaway. We're not going to go into the start of the very beginning

because prior to Buffett taking over in 1965, Berkshire Hathaway was essentially a flailing 100-year-old textile company. And fun fact, Buffett has said that Berkshire Hathaway was his biggest investing mistake. Yeah, it was. I mean, but there's lots of great positive lessons from buying a textile mill. I think his partner, Charlie Munger, longtime partner who just passed away, you know, a few days shy of his hundredth birthday, um, uh, this in this past year. Um, he's the one that pointed out to Warren, Hey, you made a mistake when you bought this textile mill. And what he meant was you, you bought a pretty bad business at a good price. And what you should be doing from now on is buying wonderful businesses at fair prices. And that's something

Warren really took to heart and he might've stumbled upon it himself, but it was really Charlie Munger who turned him on to the benefits of buying great businesses. And that's why Berkshire has grown into what it is today. It's because he's used that model of buying wonderful businesses, both in buying public equities with the float that their insurance operation generates, but also in buying whole companies that are great. And we're going to talk about some of those today, right? And he did say the best business he ever bought was Apple. And that was stock. He obviously doesn't own Apple, but he owns a chunk of that company when he bought stock in it. And he said that business is better than any business that

Berkshire has ever owned. Right. So. So then I know that Buffett started a very young age investing. I think he said he'd be much, much wealthier if he'd started even younger. But he started like, well, like 11 or something ridiculous like that. So if you can kind of take us on a quick little journey of how did a little boy with a paper route eventually buy a textile company, eventually create the Berkshire Hathaway that we kind of know today. I realize that's the whole story, but how did we even find himself buying a textile company? Yeah, I mean, he's a unique individual. And even at a very young age, I think he had focused in on earning money and being very capitalistic. And, uh, I think it started out with really fixing pinball machines

in Omaha, which is where he's from. So he earned, uh, uh, you know, profits off of that. And he eventually started studying businesses and investing in stocks on his own. Right. Um, and I would say that kind of, that was, it started to snowball rolling, right? So he was saving investing. He was buying stocks, as you mentioned, at a young age at 11 or so, but really it wasn't until Ben Graham, I think until he discovered him really kind of crystallize. And like most of us investors, you kind of go on paths that are rabbit holes that lead you in wrong directions. And he did too, whether it's technical analysis and charting and all that kind of stuff. But Ben Graham was really the guy that he first, um, you know, I think heard from and studied and really

was his mentor and said, Hey, you can, here's how you buy things for less than they're worth and make a lot of money. And of course, Ben Graham did that. Um, and Warren Buffett followed him his footsteps and and ultimately then i would say the next biggest influence is charlie munger who really said hey ben graham taught you this really cool stuff but guess what you don't want to do that anymore you want to buy really good businesses and that's what really kind of led to the to the outsized returns at berkshire hathaway is general you know generated since then so when i first started the motley fool uh many analysts put buffett on a mount rushmore consisting of just one head. So I naturally was like, okay, this guy is the goat. But then I learned a few of

the companies that were a part of Berkshire Hathaway and it was a bit baffling. So like Dairy Queen, See's Candy, a jewelry company I'd never heard of. I mean, who gets rich off of this stuff? Yes. Yeah. The second biggest jewelry store in the world is owned by Berkshire Hathaway and that's Borsheim's in Omaha. But I've literally never heard of them. I don't even know who this company brooks running shoes like who are these people yes yeah that's that's kind of amazing yeah they have i have a whole bunch of different uh businesses and i'd say like if you take a step back there's really three legs to the stool berkshire hathaway the first one being an insurance company right and a conglomeration of a bunch of different insurance companies they build

up over time and uh those businesses if they're well run and they underwrite business at good prices, it generates something called float, which is means people pay them, you know, for their policies upfront. They're going to have to pay out some of that money in the future, but in the meantime, they get to hold it. And Berkshire has a huge amount of float. I'm talking about well over a hundred billion dollars now that they get to invest. And they've also underwrote historically at very profitable rates. So they actually earn money on insurance. So they get paid to hold other people's money. So that's the first leg of the stool. The second leg of the stool is they wanted to buy whole businesses, right? So we're going to take some of that money,

then profits that we generate, we're going to buy whole businesses that are not related at all to insurance. One of those we talked about was the textile business, which no longer exists within Berkshire Hathaway, but there's 80 or 90 other businesses now that are, and they generate a diversified stream of revenues that are unrelated to insurance. And then the last stool, the third stool, uh, third leg of the stool, um, is actually investing in public equities. That's something Warren Buffett obviously has a wonderful track record. That's what most of us know him for, is being one of the world's, if not the world's, greatest investor. I know. Since 1965, shares have risen in value by nearly, what, 4 million percent, which is

baffling. Lately, Berkshire Hathaway seems to be suffering from the most champagne of champagne problems, that it has been too successful, and it now has so much money and nowhere to put it. I mean, Berkshire Hathaway is sitting on its highest cash position ever, I think, $277 billion. What a problem to have. Yeah, I think Berkshire Hathaway now owns more treasury bills than the Federal Reserve for some context. That's pretty impressive. And in the next quarter or so, they'll probably have close to $300 billion of cash to put to work. So in 2023, they generated about $37.4 billion in operating earnings from the businesses that they own collectively. So there's more and more coming in every day, Allison, like it just pours in. And it is a challenge to put all that to work. And we know Warren, he's a value investor at heart. And because of the immense size of the cash that they hold, they can't invest in small cap companies.

They're pretty much their universe of investments is limited to large cap stocks of the equity markets. And even on the acquisition front, they can't make a $50 million acquisition. It would be nothing to them, right? So they're looking at buying companies worth billions of dollars to even move the needle a little bit. And so that's a problem for them, right? And that's one that's not easy with the design that they have. And we'll talk more about that later. there's two great things about the design of Berkshire is decentralized operations. So all those businesses that they've acquired are run separately, but then centralized capital allocation. And that's the kind of real miracle. Like if you can't reinvest your money at great returns, you send it back to Omaha and Warren Buffett and three other people will kind of invest it. And that's their job. So centralized capital allocation, but we've seen with the large sums that they have. And the four people that are now doing it, we can talk more about them, but there's challenges. It's hard, you know, with four people to put that immense amount of capital to

work. And it's not really 300 billion, they need to hold at least 10 billion for the insurance companies. And they double that. So that's 20 billion. So it's roughly let's call it 280 billion that they have available to reinvest. I mean, not that I mean, yeah, once you do that math, it really doesn't seem like that much, does it? Just pocket change. Just pocket change. Well, I mean, Buffett is also called the Oracle of Omaha. So when people see this much cash lying around, they also start to wonder, is it because he's bearish, right? People want to look to him to be like, oh, should I also have a massive $300 billion pile of cash lying around? I mean, if you can, yes, go for it. But how much do you think about that? Whether, okay, the cash,

it's a pile of cash because he's bearish and waiting to deploy it at a better time. So I think that's a really good question, right? Because we care what people say. And we know Warren Buffett's always been an optimist and he's always been all in on America, right? But I kind of judge people more by what they do than what they say. And I was at the most recent annual meeting um had my youngest son there my brother was along as well and he was asked about this and and he said basically uh people ask him because interest rates went up and you're earning more on money market funds and stuff like that is that reason why you sold down your apple position you have so much cash now he said it didn't matter irrespective of what

interest rates were and if they were still at zero i would hold this much cash today and his answer was, it's perfect. Buffett thinking ahead, the U S is running huge deficits right now about $1.8 trillion. And I think what he's looking at, it doesn't matter who gets elected. Um, the reality is we're running big deficits and taxes are going to go up. So his answer to that was I'm anticipating much higher future taxes on long-term capital gains. And so I'm willing to take some off the table here on my apple position and hold more cash now today so um that's his kind of macro view of the world and if you look at it from a historical standpoint taxes are very low right now and when you're running big deficits it's not out of the ordinary to say hey those

might go up in the future and i think that's uh that's his estimate all right one thing is for sure buffett is old i mean this is a compliment despite having the diet of a six-year-old he's managed to live to be 94. And it's not just him. You mentioned he has a team that he works with. So what do you anticipate should a steady diet of Cokes and chicken nuggets finally catch up to him? Well, I mean, Buffett is a huge company and he oversaw all of the 80 to 90 subsidiaries. Now, those have been split, right? Ajit Jain is his insurance expert. So all insurance companies report into Ajit. And then Greg Abel basically oversees all the rest. So I'd say that is the answer in the short term. Greg Abel is going to be the single kind of head. He's going to play

Warren Buffett's role when it comes to capital allocation. So all capital allocations, though, Ted Weschler and Todd Combs will be helping to make those decisions. Greg Abel will sit above them. He will oversee them on stock investments and those types of things. I think the future for Berkshire is probably going to break down even more, I would think. I wouldn't be surprised if you take the non-insurance operations and maybe put two or three other presidents in charge of those three divisions that kind of report up to folks. Just because Warren Buffett could hold all this information in his head and converse and know about all those other businesses, there's not many people like Warren Buffett, right? Not many read 750 annual reports a year and followed companies

for decades. And so I think you'll see a little bit more management, not a ton. I think Berkshire has 26 people at headquarters right now for almost a 400,000 person organization, but I think it'll go up from 26. All right. I think we'll see a little bit more infrastructure. The other thing on capital allocation is I think we'll see some of that be pushed down in the organization more, right? I don't think four people is enough to allocate, you know, $300 billion. I think Berkshire will build in some ways where some of these other companies can go and make quicker at a quicker pace, bolt on acquisitions and things. And the last thing I'd say it might be possible as a dividend. And that's something that Warren Buffett said he would never do. It's double taxed.

I think people all understand that. And that's, I think the main reason why he said he would never pay one. But I think paying a dividend after Buffett's gone will relieve some pressure on his successors to kind of feel the need to put all that money to work right away. It'll take some pressure off of them. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. I'm Ricky Mulvey. Thanks for listening. We'll be back tomorrow.