Did Buffett Make a Bad Deal?

Warren Buffett has taken a lot of criticism lately.

Some have accused him of talking up his own book. Others claim he was too early in having Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) make investments in General Electric (NYSE: GE  ) and Goldman Sachs (NYSE: GS  ) . Still more naysayers claim that Berkshire's writing stock index puts was both irresponsible and hypocritical -- especially given his repeated warnings about derivative exposure.

I've read Bill Mann's take on Buffett's recent plug for the market, and I agree that Buffett's motives appear pure. He truly believes in the long-term success of the stock market, which explains both why he said so in The New York Times and why he was willing to put Berkshire's money on the line by making bets that stock indexes would rise over the long haul.

The arguments against the investments in GE and Goldman, however, are a different story. They indicate a fundamental lack of understanding about the investment Buffett made. So for those of you who haven't studied these issues in detail, here's some more information about this sometimes confusing investment.

Preferred isn't common
The comment I've heard most often centers on the fact that when Buffett made his investments in these two companies, their share prices were much higher -- Goldman closed around $125 on the day of its announcement, while GE closed at $24.50. Now that both have dropped quite a bit -- about 45% and 30%, respectively -- pundits assert that Buffett's preferred investment has suffered similar losses.

The problem with that analysis is that it assumes that preferred shares trade in lockstep with the common shares that most shareholders own. That assumption, as it turns out, is incorrect.

Two components to preferreds
The key distinction between preferred shares and common comes from the different dividend rights. As their name suggests, preferred shares have first priority to any stock dividends a company pays out; common shareholders can't get a dividend unless preferred shareholders get paid in full. Plenty of companies offer preferred securities, including Alcoa (NYSE: AA  ) , Fifth Third Bancorp (Nasdaq: FITB  ) , and Duke Realty (NYSE: DRE  ) .

Typically, preferred shares pay higher yields than their common counterparts -- as is the case with these companies. Buffett will receive 10% dividends annually from each. For many preferred shares, the dividend is the only thing shareholders get. As a result, these shares tend to trade like a subordinated bond, rather than an equity.

So to get a sense of what these preferred shares are worth, it's helpful to look at the companies' bonds. Recently, GE debt carried rates between 6% and 6.5%, while Goldman offered 7.5% rates. Since preferred shares are further down the capital structure ladder, it makes sense that they'd justify a higher rate -- and at a glance, 10% seems reasonable.

Free convert?
Based on those numbers, one could easily conclude that the deal Buffett got was a fair one, even if he only had the right to the dividend. But the warrants that allow Buffett to convert his investment to shares could prove much more valuable in the long run, if GE shares recover above $22.50, and Goldman moves above $115.

To get a sense of the value of that right, you can look to the options market. Berkshire's conversion right lasts for five years. There aren't exchange-listed options with expirations that far in the future, but Goldman 115 calls that expire in January 2011 would have fetched $11.35 per share yesterday, and GE 25 calls expiring in January 2010 went for $1.70. And that's with both stocks trading at multiyear lows -- the options could rocket in value if shares recover between now and 2013.

Say what you like about Buffett's bullishness on the stock market. But don't mock him for his investments. Of all of the negative things I've heard about his preferred share score, the only one I agree with is how unfortunate it is that regular investors couldn't get in on the same deal.

For more on taking advantage of great bargains now, read about:

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Fool contributor Dan Caplinger has always liked the idea of preferred shares. He owns shares of Berkshire and General Electric. The Fool also owns shares of Berkshire Hathaway, which is a Motley Fool Inside Value selection and a Motley Fool Stock Advisor pick. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy always understands.


Read/Post Comments (17) | Recommend This Article (28)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 14, 2008, at 4:09 PM, madmilker wrote:

    jus a 'clickjacking' flaw tat he got from Bill..

  • Report this Comment On November 15, 2008, at 5:21 PM, weiwentg wrote:

    But wait, ordinary investors can get in on the deal indirectly - by buying shares of Berkshire Hathaway!

  • Report this Comment On November 16, 2008, at 10:15 AM, markwg1 wrote:

    I think Buffett has made a good decision to start investing in the month of September - October 2008... time where house sales start to recover: In many parts of the US, house sales were already picking up since Oct 2008 (up 120% in San Jose area in Oct 2008 Vs Oct 2007), up 65% in San Francisco, up 45% in Valley, etc. Home prices were already dropped 35% on avg in US since the peak in summer 2007.

    Link: http://www.businessweek.com/ap/financialnews/D93V74M80.htm

    Once the home prices recovers (assume we are now very close at the bottom of housing market), then economy activities (e.g. constructions, etc.) will be picking up again.

    I think Obama should build more public housing (like China) to make housing more affordable to their citizens! so the Americans will have more $$ to spend... instead of wasting their $$ just to pay their cars, mortgages, etc. Build more highways too! so people can drive more... to stimulate the struggling auto sectors.

    GO OBAMA!

  • Report this Comment On November 16, 2008, at 4:12 PM, starbucks4ever wrote:

    My complaint against Buffett is that he's wasting money on useless oil stocks like BNI and COP...

  • Report this Comment On November 16, 2008, at 8:24 PM, twcooper wrote:

    ^^Since when was BNI an oil company...?

    Whenever I get worked up about idiots who misunderstand Buffett's investment practices, I come to the fool to get my dose of Buffett-lovers.

  • Report this Comment On November 17, 2008, at 3:42 AM, starbucks4ever wrote:

    Buying a railroad is a bet on oil because when oil is down, railroads have no chance to compete against truckers.

  • Report this Comment On November 17, 2008, at 9:57 PM, 123go100 wrote:

    got to wonder if warren might not end up like one of the founders of gmc during the great depression ,dieing in a flophouse broke.

  • Report this Comment On November 20, 2008, at 9:48 PM, TMFAleph1 wrote:

    Dan --

    Nice article. It's amazing the number of people who focus on the fact that the warrants are out-of-the-money as evidence that Buffett has "lost his touch". It's a mistake to focus on the warrants -- they are a sweetener that Buffett received at no cost, yet they may top up the 10% dividend on the preferreds.

    My hypothesis is that people are so motivated to catch the Oracle out that it ends up skewing their perception.

    Alex Dumortier (XMFMarathonMan)

  • Report this Comment On November 20, 2008, at 9:51 PM, TMFAleph1 wrote:

    For another example of the way in which Buffett's trades are misunderstood, check out my article, "What's Wrong With Berkshire Hathaway?":

    http://www.fool.com/investing/value/2008/11/20/whats-wrong-w...

    Alex Dumortier (TMFMarathonMan)

  • Report this Comment On November 21, 2008, at 11:57 AM, fibreoptik wrote:

    yeah sure... we can all buy shares of Berkshire... great idea :P

  • Report this Comment On November 21, 2008, at 3:41 PM, britpick wrote:

    fibreoptik

    you can actually buy Berkshire. Use sharebuilder and you can buy partial shares and build up to whole ones over time... just a thought

  • Report this Comment On November 21, 2008, at 3:42 PM, Jimminynix wrote:

    The suggestion that we invest more in a soon to be obsolete method of transport - cheap driving of cars - needs to be looked at by our entire culture soon. When we have Oil at 150+ (2010 - 2012 easy) gas will climb past 10/gal and the race for any alternatives so that we do not have to give up the addiction to solo auto nirvana and our suburbs and 3000 mile cheap lettuce, will be a great time for scientific breakthroughs, but it will also be a time that future historians will see as the largest case of DENIAL that a way fo life was doomed ever. I guess my fondness for the writings of Kunstler so inarticulately and lamely expressed coudl unintentionally discredit Kunstlers good work - so read him in spite of my lameness - he is great!

  • Report this Comment On November 21, 2008, at 3:44 PM, Jimminynix wrote:

    my comment was speciifcally directed at another comment shared above.... in the spirit of "helpfulness" not as a rant...

  • Report this Comment On November 21, 2008, at 4:27 PM, Muhammad4M wrote:

    Warren Buffett is my hero but im afraid that the index bets he took,credit default swaps,deposit insurance on small banks which are wobbly are all problems not easily erased.

    Rumour on wall street is that the Goldman investment was actually margin Buffett had to put up on his index bets via Goldman.

  • Report this Comment On November 21, 2008, at 7:14 PM, damastr wrote:

    Agreed that preferred shares do not move in lockstep with common, but does anyone have any idea what prices did Mr. Buffett got those shares at and what are the prices now? I can't seem to find the answer anywhere. The prices today are important because what if he wanted to sell them today -- there has to be a quote for it.

  • Report this Comment On November 22, 2008, at 11:59 AM, wonderousdragon wrote:

    Warren Buffett is an insider, when he makes his moves, you've got to know that he knows what's going to happen, if you follow the money you will find that the rich don't lose, the little guy does.

    They keep us in the dark, speculating and confused, but know this, if the government is giving away our tax dollars to the rich, Warren Buffett knows what companies are in line to get this free billionaire money. The super rich get the billions and the weak little people get the shaft!

    Try to take a look at this website I've found, it gives you some insight on some of the schemes and other activity the rich are inclined to resolve to to steal our wealth and run if they're found out!

    http://www.kenlayisalive.org/

  • Report this Comment On November 22, 2008, at 10:09 PM, 123doom wrote:

    Yes, he most certainly did, made two bad deals in a row. Don't get me wrong, I like Buffett. He is a good man. But we all make mistakes. Just take a look at his BRK share prices. It had dropped off a cliff in a very short time. Correctly me if I'm wrong, I believe the A shares are trading above $100k/sh. in October, but today it is trading at around $80k, a 20% plus hair cut. The experts in Wall Street told us stock prices does not lie and the market price told us that Wall Street does not like the investments that he made within the last month. With his vast stock holdings in C, AXP, BAC, etc., companies that are taking a beating day after day, I would not be surprised to see BRK taking another 20% losses in the not too distant future, especially if CitiBank went bankrupted. This is not to scare people to sell any stocks, just my own foolish opinion and hoping that it won't come to pass, for the sake of people investing with Warren.

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