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Warren Buffett

Warren Buffett’s Shallow Votes of Confidence

October 03, 2008 02:16 PM
by Anne Szustek
Investors view Warren Buffett’s investments in GE and Goldman Sachs as a sign of confidence in these companies. But Buffett already has one foot out the door of each.

Buffett Makes Measured Move into GE

This week, Berkshire Hathaway, led by founder and CEO Warren Buffett, purchased $3 billion in preferred stock in General Electric.

Many investors and analysts were heartened by Buffett’s move, considering it a vote of confidence in GE and a possible bottom in the stock market. Indeed, GE leveraged the news to sell $12 billion of common stock in a separate public offering, albeit at a 7 percent discount to the previous market price. Since then, the stock has maintained its value despite harsh trading conditions.

Buffett explained to CNBC that GE was “the backbone of American industry,” continuing, “they’ve become tainted as every company is that has to borrow a lot of money all the time. They’re going to be around in five or 10 or 100 years from now and, if you buy at the right time, you’ll probably make some money.”

The GE buy-up came eight days after Buffett bought up $5 billion in preferred stock at Goldman, with a right to buy up an additional $5 billion in common stock at an 8 percent discount from the previous day’s closing price. Goldman Sachs also sold an additional amount of common stock at the same time, and its stock has traded higher since then.

But would-be buyers of either company’s common stock should also consider the highly favorable terms on which Buffett invested. As a holder of preferred stock, upon a sale or liquidation of the company, Berkshire must be paid back its entire investment before holders of common stock receive anything. So while buyers of common stock may seem to be hopping on the same bandwagon as Buffett, he alone has the right to get off first. Further, the preferred stock in each company carries a 10 percent dividend, which is twice the yield of GE’s common stock and 10 times that of Goldman Sachs’ common, and the preferred dividend must be paid before the common. And lastly, while neither issuance of preferred stock is convertible, each company also issued to Berkshire a warrant to buy a dollar amount of common stock equal to the investment in preferred stock. This 100 percent warrant coverage is substantially higher than a blue-chip issuer such as Goldman Sachs or GE would ordinarily be expected to provide.

Taking the liquidation and warrant provisions together, Buffett shares in all of the upside with the common stock, but almost none of the downside. For a new buyer of GE common stock to break-even, the company must maintain its current equity value of $225 billion. For Buffett to break-even, GE need only maintain equity value of at least $3 billion (plus any other preferred stock of equal or great priority). Thus if GE stock should plummet 98 percent, common stock investors would lose, yet Buffett would remain unscathed.

One key difference between the two investments is that Goldman could call back its preferred stock, at a 10 percent premium, at any time. GE has to let Buffett hold on to the preferred stock for at least three years before the company can call it back. On the other hand, Goldman’s four top executives had to agree not to sell more than 10 percent of their company shares for three years, or until Buffett’s investment is redeemed.

Peter Cohan, a GE stockholder and a professor at Babson College, told Canada’s Financial Post, “I’m looking at Goldman and GE and I’m thinking we must be in some really serious yogurt. The terms that are being paid to Buffett are just outrageous.”

Opinion & Analysis: Buffett's protected, and not infallible

Bespoke Investment Group wrote on financial news and analysis site Seeking Alpha, “while the GS warrants have for the most part traded in the money, the GE warrants are already trading in the red.” GE shares closed at $22.13 on Wednesday—already below the discounted price a day after Buffett announced his stock acquisition.

While Buffet is undoubtedly one of the greatest investors of this century, he isn’t immune to mistakes, as Buffett is often the first to admit. He devoted a section of the 2007 Berkshire Hathaway shareholders’ letter to what he considers bungled investments. His 2007 letter to Berkshire Stockholders includes a section titled, “The Good, the Bad and the Gruesome.” In the part he calls “confession time,” Buffett acknowledges turning down an opportunity to buy an NBC affiliate for $35 million that is now worth many times that amount, and issuing stock of Berkshire that is now worth $3.5 billion to buy Maine-based Dexter Shoe Company, which he now deems worthless. Buffett also predicts, “I’ll make more mistakes in the future—you can bet on that.”

Related Topic: Companies get Buffett liquidity during credit crunch

GE is feeling the squeeze of the credit crunch. It’s carrying $90 billion in commercial paper, a type of short-term, unsecured loan. And Fox Business News recently deemed the financial disclosures of GE Capital “as transparent as a vat of molasses.”

As several corporations face a tight lending environment, Berkshire Hathaway has stepped in as a financier of some major recent M&A deals. In July, the conglomerate put $3 billion towards Dow Chemical’s $18.8 billion buyout of specialty chemicals manufacturer Rohm & Haas.

Buffett and Berkshire also provided $4.4 billion in debt financing in April to Mars for its $23 billion purchase of Wm. Wrigley Jr. Co, as well as buying a $2.1 billion minority stake in the chewing gum giant. The Wrigley takeover “also shows how the debt market has shifted to cause acquirers to back deals with more funds,” wrote business publication Mergers Unleashed.

Reference: Preferred stock


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