Thursday, October 2, 2008

My Take On Buffett's Take Of GE Stake

With the ink barely dry on Buffett's recent agreement to invest in Goldman preferred shares, the sage of Omaha is on the move again. This time he's taking a stake in General Electric. As I cautioned on the Goldman deal, you need to look beyond the headlines to understand what this signifies. The press has been pushing the idea that these investments are evidence of Buffett's confidence in America, its leadership, and the stock market. We can't get inside Warren's head, so we really don't know what he's thinking, but the structure of these deals are designed for one thing -- to protect (and reward) Buffett.

As with the Goldman deal, Buffett is buying perpetual preferred stock at a yield of 10%. That works out to an annual dividend payment of $300 million on his $3 billion investment. GE will have the right to buy back the preferred shares after 3 years, but at a 10% premium, or another $300 million. Buffett is also getting warrants to buy $3 billion of common stock at $22.25 within the next 5 years. GE stock was already at $23.50 when the deal was announced and rose further following the announcement, as all Buffett deals do. The stock closed yesterday at $24.50, for a paper profit of -- you guessed it -- another $300 million for Buffett.

Buffett does wonderfully with this investment if GE just stays in business. He'll get his 10% from a highly-rated company in an environment of low-returns. If the stock goes up, his return will go up due to the warrants. Notice, again like the Goldman deal, GE also announced that it would raise a bundle of cash ($12 billion) in a common share offering in conjunction with the Buffett investment. I'm sure this was a precondition of Buffett's for his investment. This extra $15 billion of cash for GE should certainly ensure that GE stays in business and is able to pay Buffett his 10%.

It should be clear that this is yet another fantastic deal for Buffett. This type of deal isn't available to the average investor. We can buy the common shares of GE and incur all of the risk that comes with the common (including the $300 million less in annual cash flow due to the payment to Buffett), but Buffett is able to secure an almost riskless 10% yield with a free call option on the common shares.

How can this possibly be interpreted as a vote of confidence in America or the stock market? To the contrary, this deal is designed to provide incredible protection to Buffett in light of the risk in our economy and market. If Buffett wanted to signal any optimism concerning the stock market, he would have invested in the common shares of GE at a price very close to the current share price.

Disclosure: The Rubbernecker is long guaranteed 10% returns but short roughly $3 billion.

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