Why I'm Giving Up On Bank Shares

Published in Investing on 4 July 2012

A Fool adds banks to his list of sectors to avoid.

In my 30 years as an investor, the only type of business that I've always refused to invest in is the tobacco companies. Yesterday I added banks to that list, and I'm now having a good think about whether insurance companies should be on there as well.

The straw that broke this particular camel's back was the revelation that the FTSE 100 (UKX) member Barclays (LSE: BARC) was fined £290 million for manipulating the London Interbank Offer Rate (Libor), and that many other banks are being investigated for behaving similarly.

Even though they may be let off the hook following reports that they were encouraged to do this by the Bank of England and "Whitehall officials", I'm steering clear as I'm no longer prepared to invest in a sector where it seems to be standard practice to rip off your customers and companies' accounts are becoming increasingly hard to interpret.

Ridiculously complex

The balance sheets and profit and loss accounts of banks (and insurers) are such complex beasts that even the experts can be fooled. The big problem is that it is easy to turn a loss into an accounting profit in this sort of business by making overoptimistic assumptions about the future such as the level of bad debts, claims and the returns that you'll earn upon your investments.

Many towns and cities in America are now facing bankruptcy because they did just this with their pension schemes over many years and ran up massive deficits as a result. You can only deny reality for so long before the truth eventually catches up with you.

History tells us that banks love to gear up their exposure by using derivatives; financial instruments which Warren Buffett called "weapons of financial mass destruction" back in 2003. This lead to the crash of 2008-09 when several years of passing off bad debt as good debt nearly led to the collapse of the American financial system.

The three that I do own

That said, I've only ever owned shares in one bank, and I still own shares in three financial companies, which I'm not planning to sell. The largest holding is in Buffett's conglomerate Berkshire Hathaway (NYSE: BRK-B.US), which is really a group of insurance companies combined with a much larger collection of non-insurance businesses like the Burlington Northern Santa Fe railroad.

Then I have a much smaller stake in Prem Watsa's Fairfax Financial Holdings (NYSE: FFH.US), a diversified insurer that's known as Canada's equivalent of Berkshire Hathaway because Watsa's philosophy is similar to Buffett's.

Finally there's a very small holding in Lloyds Banking Group (LSE: LLOY), which is a pure punt on the economic recovery. The old Lloyds TSB used to be Britain's most conservatively run big bank, but its directors threw over two hundred years of history out of the window during the financial crisis of 2008 when they decided to ruin the bank by buying HBOS. I'm hoping that enough of the old culture remains.

Buffett and Watsa have demonstrated over the years that they take their responsibilities very seriously. They both own a substantial proportion of their respective companies, so they have plenty of skin in the game, and this is a great incentive to not bet the farm on a reckless acquisition, as The Royal Bank of Scotland (LSE: RBS) did when it bought ABN-AMRO.

Do they understand themselves?

Another thing that puts me off financial companies is that I doubt whether anyone -- and I really do mean anyone, including the top management -- has a complete picture of their business. The multinational banks with investment banking arms seem to be particularly prone to this because they have become so complex.

No doubt there will be a few bargains thrown up in the wake of the fallout from the Libor scandal. But I feel much more confident that Mark Cavendish will win today's stage in the Tour de France than of my being able to make money by buying the shares of most banks.

However, as Nathan Rothschild said, you should "buy at the sound of cannons". Given the hammering that banks and other financials, such as the composite insurer Aviva (LSE: AV), have taken over the last few years, investors who are bolder than me could do nicely by taking a close look at the sector. I'll sit this one out as there are plenty more fish in the investment sea.

Buffett buy signal! The billionaire investor has found an attractive large-cap right here in Britain! Discover what he bought and the price he paid in this special report -- "The One UK Share Warren Buffett Loves" -- it's free.

Further investment opportunities:

> Tony owns shares in Berkshire Hathaway, Fairfax Financial Holdings and Lloyds Banking Group but he doesn't own shares in any of the other companies mentioned in this article. He has bet that Mark Cavendish will win stage 4 of the 2012 Tour de France.

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

richjfool 04 Jul 2012 , 10:11am

I can well understand the desire to stay away from banks. There seems to be a lot of skeletons in a lot of cupboards currently, - many perhaps yet to be discovered.

inijames 04 Jul 2012 , 11:28am

Have you looked at Wells Fargo? Buffet's a fan, and I understand they focus on retail banking and keep away from investment banking.

QuantumDealer 04 Jul 2012 , 12:00pm

It is perhaps understandable to give up on UK banks but take a detailed look at Svenska Handelsbanken...a very robust company, bank and stock. Good dividend, well managed and experienced Board. Not all banks are as bad as UK or southern European banks.

BrnzDrgn 04 Jul 2012 , 1:18pm

This seems to make more sense to me than other peoples views. I also hold a small amount of Lloyds shares, if you call 10k a small amount that is.

Brockasaurus 04 Jul 2012 , 1:23pm

I vaguely recall a Nassim Taleb quote about banks making reasonable profits most years and periodically making a colossal loss large enough to eclipse all cumulative gains.

theRealGrinch 04 Jul 2012 , 5:35pm

I said this about the 400 pages or so of old mutual many years ago.

brokerjohn 04 Jul 2012 , 9:39pm

It wasn't so long ago that Fool reported that banking shares were good value.

There's lots of value out there but no upward movement. The FTSE 100 is lower now than it was 5 years ago.

4spiel 05 Jul 2012 , 7:45pm

Any holding in LLOY or RBS must be considered as along term hold that might deliver. Meanwhile both these banks have dividend paying prefs -the NWBD and the LLPE C & D are well nkown. Holding some of these provides some return for the currently sterile ordinary shares unless you are a complete cynic !

ANuvver 06 Jul 2012 , 4:44am

What do they say about never buying into a lawsuit?

There's so much potential liability now throughout the whole sector over the Libor affair, and it will drag on for years or even decades. Given the fundamental nature of the banking business, how on earth can any investor have any faith in reported levels of contingency funding?

It's a bit like the incurable gambler knowing that the rainy-day fund is hidden in the cocoa tin.

I agree with 4spiel - if you have, hold and hope; otherwise leave bank shares to the traders. I don't believe this is a currently a sector that the private investor has a hope of handicapping successfully.

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