“Its amazing how the guy ******* does it!!!!” That’s what I uttered when I read the details of Warren Buffett’s investment in Goldman Sachs. A lot of financial press interpreted this to mean that the prospects of financial stocks are very good here on. Indeed the price of Goldman rose 6.4% to $ 133. All these guys are dumb idiots!!! What is actually means is that the existing shareholders suffer and Sovereign Wealth funds who have been putting money in financials would do well to hand over their money to Buffett to manage.
Lets analyse the deal in detail.
Number 1: The investment is NOT equity investment. The investment is in the form of preferred shares with a fixed dividend payment of 10% p.a. This interest rate is similar to those paid by junk bonds issuers rather than one paid by institutions where ‘investors’ have confidence. (For the true yield on these bonds and the true cost to Goldman and existing shareholders of Goldman, keep reading ……..)
Number 2: The dividend on these preferred shares will have to be paid from after tax earnings unlike the normal interest on junk bonds which is tax deductible. Given such a high cost, it will be in the interest of Goldman Sachs to redeem these shares as soon as possible. However there is a redemption premium on these preferred shares of 10%.
Number 3: These preferred shares have been subscribed to after a lot a financial institutions have failed, after Goldman and Morgan have been left as the last men standing, after these two have been converted to banks and after the US government has announced a $ 700 billion bailout package. Huh…
Number 4: These preferred shares come with warrants giving an entitlement to subscribe to $ 5 billion worth of shares at a price or $ 115 a share. (These shares were already in the money by $ 10 before the deal was announced. Now they are in the money by $ 18). Hence Buffett’s Berkshire gets all the upside of an equity investment in Goldman without the downside.
Let’s indulge in some fantasy and do some time travel into the future to see how the investment has turned out for Buffett.
September 24, 2009
Goldman Sachs today announced that it was redeeming the preferred stocks issued to Berkshire Hathaway owned by billionaire Warren Buffett. The share price of Goldman Sachs moved up by 4% as analysts upgraded the earnings estimates of Goldman Sachs on retirement of the high cost funds to be replaced by low cost funds. Simultaneously Berkshire also announced that it had sold the equity shares held by it in Goldman Sachs at an average price of $ 172.50 per share. It may be recalled that these shares were just acquired on conversion of warrants at a price of $115.
Analysts simultaneously put out a buy on Berkshire as analysts figured out the truckloads of money Berkshire had made on this deal. Berkshire has made 10% by way of dividend on preferred shares, 10% by way of redemption premium on preferred shares and 50% by way of appreciation in the stock price of Goldman and consequent profit on the warrants. This adds up to a return of 70% in one year and $ 3.5 billion on an investment of $ 5 billion.
May 7, 2010 Qwest Center, Omaha,
Warren Buffett replying (while grinning from ear to ear) to a shareholder’s question on the Goldman Sachs investment in the past year ” We really had very little risk in the deal. The equity shareholders would not have got a cent till we had been paid our dividend and principal and the redemption premium. Further the pessimism was really overdone as far as Goldman Sachs and Morgan Stanley are concerned. Shareholders should however not expect similar returns from our future investments as our size has really become very big now. You should expect a return of 7% to 10% in the future as compared to 70% that we made on Goldman (takes a sip of Cherry Coke)……. Charlie?”
Charles Munger ” I think 7% to 10% for the future looks very optimistic” (Audience laughs ……..all the way to the bank)