The multi-billion-dollar bets by Warren Buffett on Goldman Sachs Group Inc. and General Electric Co. (GE) are good for sentiment around those companies and the stock market generally. But they shouldn’t be interpreted as regular stock tips.
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The $5 billion (Rs23,500 crore) the Sage of Omaha put into Goldman and the $3 billion Buffett is stumping up for GE are in the form of preferred stock with 10% annual dividends.
In both cases, the preferred stock comes with warrants over an equivalent dollar amount of common shares—essentially, the right to buy shares at just under the current price at any time in the next five years. The investments in GE from Buffett’s company, Berkshire Hathaway Inc., announced on 1 October includes warrants to purchase shares at $22.25 a share, a 13% discount to GE’s closing share price on 30 September. This was part of the $15 billion GE said it was planning to raise. Goldman Sachs had announced its similarly structured agreement with Berkshire on 23 September.
These deals provide a neat structure for investors eager to protect against possible losses. Buffett only needs to believe that Goldman and GE will remain sufficiently solvent to pay the preferred dividends. As long as that faith isn’t misplaced, he’ll get, at worst, a 10% annual return in perpetuity.
Of course, as preferred shareholders of Lehman Brothers Holdings Inc. can attest, Buffett can lose real money if either company actually goes bust, and the perpetual preferred shares can, to an even greater extent than bonds, lose paper value if cash flow gets tight.
But this is less risky than buying common stock, the owners of which receive no dividends until Buffett’s dividend is paid in full and who are first in line to take losses.
Meanwhile, the warrants give Buffett extra gravy as and when Goldman or GE shares recover. His warrants were actually in-the-money to the tune of 10%, give or take, in both cases, giving him billions in theoretical option value as well.
Of course, an investor in GE’s planned offering of at least $12 billion of common shares will gain, too, assuming the shares rise. But Buffett’s structure cuts off a lot of downside and amplifies the upside. That’s why it would be a good template for any taxpayer money used to recapitalize troubled banks.
But that’s also why ordinary investors shouldn’t necessarily take the Nebraskan billionaire’s involvement as a tip to call their stock broker. Sure, his involvement boosts sentiment by suggesting a smart guy is finding bargains. And an investment from the picky Buffett can make companies look like the stars of their respective sectors. But it doesn’t have to mean he thinks the shares are poised to shine.