Why Is Buffett Avoiding Small-Bank Investments?

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Warren Buffett likes community newspapers and he likes big banks. So, why not community banks, too?

It's not a preposterous question to those who follow the Oracle of Omaha, though small banks' size might work against them.

Buffett, the chairman and chief executive of Berkshire Hathaway (BRK), has made banks a big part of the company's investment portfolio. Berkshire is the largest shareholder at Wells Fargo (WFC) and its portfolio includes Bank of New York Mellon (BK), M&T Bank (MTB) and U.S. Bancorp (USB). Berkshire owns $5 billion in Bank of America (BAC) preferred stock and warrants for common stock.

Buffett's public views of the banking industry have been rosy. "The American banking system is in fine shape," he said at Berkshire's annual meeting last month, because it has "buttressed capital in a big way" and banks "have liquidity coming out of their ears." On Monday, Berkshire said it wants to buy $374 billion in mortgage assets from Ally Financial's bankrupt Residential Capital unit.

Buffett has had nice words for small banks in the past. In 1995, he called Bank of Granite in Granite Falls, N.C., "the best little bank in America." FNB United (FNBN) bought Bank of Granite in October in a deal backed by Carlyle Group (CG) and Oak Hill Capital Partners.

Buffett has shown in the last year that he believes in the power of local ties in small communities, buying newspapers in small cities like Winston-Salem N.C., and Dothan, Ala. "In towns and cities where there is a strong sense of community, there is no more important institution than the local paper," he said last month.

The "strong sense of community" theme should sound familiar to those who follow community banking and banking in general is a sound place to invest, says Josh Siegel, the chief executive of StoneCastle Partners. "More money has been made in banking than almost any other industry in the history of the planet," he says.

Buffett has made it clear that he wants to invest Berkshire's copious piles of cash. What may bar him from investing in small banks is that most are simply too small for a minority stake. Buying banks outright would trigger new regulation, says Frank Schiraldi, an analyst at Sandler O'Neill & Partners. Buffett is "constrained by the large sums of money that Berkshire has to move around, and the fact that he wouldn't want to be regulated as a bank holding company," he says.

Buffett could string together several investments in small banks, but it may not be worth the effort. "It takes about as much time to make a $5 million investment as it does to make a $500 million investment," Siegel says. "That's a lot of deals."

Marc Hamburg, a senior vice president at Berkshire, did not return a call seeking comment.

If an investor owns more than 24.9% of a bank, it becomes subject to the Bank Holding Company Act. Buffett's options are limited if he wants to avoid being regulated under that law, says David Kass, a business professor at the University of Maryland who follows Berkshire. Most, but not all, of Berkshire's minority stakes are at least $500 million, he says.

Based on market capitalization, at least three banks with less than $25 billion of assets could be on Buffett's radar. He could invest more than $500 million without crossing a 24.9% stake in SVB Financial Group (SIVB), Hancock Holding (HBHC) or Valley National Bancorp (VLY).

For example, the $16 billion-asset Valley National had a market cap of $2.2 billion at June 11. A 24% stake in the Wayne, N.J., company would equal about $526 million.

Berkshire's range of small bank investments is potentially widened by the addition of two investment managers, Todd Combs and Ted Weschler. Each has made investments of less than $500 million per investment, Kass says.

That could allow for smaller bank investments. For instance, the $4.9 billion-asset Independent Bank (INDB) in Rockland, Mass., had a $571 million market cap at June 11. If Berkshire were to invest in Independent without surpassing a 24.9% stake, the investment would total $137 million.

That's too small for Buffett, but maybe not Combs or Weschler, says Meyer Shields, an analyst at Stifel Nicolaus who follows Berkshire. "It could be interesting is if the newly hired folks have had exposure to banks," he says.

Berkshire's foray into community newspapers also shows that Buffett may be willing to break his own rule for investing in smaller businesses, Kass says. Berkshire agreed to buy Media General (MEG) for $142 million. "The $500 million threshold is not set in stone anywhere," he says.

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