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
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
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.
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:
Are you a Buffett-style investor? At Motley Fool Inside Value, we follow some of the same tenets Buffett uses to pick investments, seeking out stocks with a margin of safety to give you comfort even in a down market. See what we're recommending for investors right now with a free 30-day trial.
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.