Warren Buffett is Buying Four Percent of Goldman Sachs

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Did you see they’re having a good old fashioned bank-run in Hong Kong? The New York Times reports that, “Throngs of depositors lined up outside the headquarters and branches of the Bank of East Asia here on Wednesday to withdraw their money, highlighting widespread anxiety in Asia that Wall Street’s recent difficulties might spread across the Pacific.”

Don’t worry, though. Warren Buffett is buying. And he’s not buying an electricity company this week. He’s buying about four percent of Goldman Sachs.

Is Buffett’s buying a sign that the bottom is in for stocks? After all, didn’t John Templeton plunk down money for every share selling for under a buck on the Dow at the bottom of the bear market that began with the ’29 crash? “Before you rush out to buy Goldman’s stock,” writes my friend Porter Stansberry, “you should consider a few points”.

“First, you can’t buy the kind of stock Buffett got on any market, anywhere in the world. Berkshire Hathaway is buying $5 billion of perpetual preferred stock with a 10% coupon. These shares are senior to both Goldman’s other preferred stock and its common stock. That means no other shareholders will receive any dividends until Buffett has been paid his 10%, in full, each year.

“And that’s not all… To sweeten the deal for Buffett, Goldman agreed to include a warrant (a long-term call option) that entitles Berkshire Hathaway to buy an additional $5 billion in regular common stock, at $115 per share. (Goldman’s trading for about $130 now.) Thus, if Goldman can turn things around, Berkshire will receive an enormous payday down the road. It will be entitled to buy stock at $115, no matter what the price has risen to five years from now.

“Most investors have no idea what this means. When they read about a warrant being granted, they just shrug. They can’t do the math to figure out how much Goldman has given to Berkshire. It’s like reading Greek to most people. So let us tell you what no newspaper will…

“The value of an option to buy stock in the future at a fixed price is based almost entirely on the duration of the option. The further out you go in time, the more valuable they become. Right now, the only similar options you can buy on Goldman are $120 calls that expire in January 2011 – about two and a half years from now. These options would cost you $42 to buy today.

“Using these options as a rough guide, our options trading expert, Jeff Clark, estimates the options Buffett received from Goldman are worth about $78 each. On a $5 billion position, that’s a total value of $3.2 billion.

“In other words, Buffett received a security worth about $3.2 billion in exchange for his $5 billion investment in a high-yielding preferred stock. His net exposure is only $1.8 billion. On this capital at risk, he’s getting paid $500 million per year. That’s a 27.7% annual return. And he may eventually end up owning 10% of the company.”

The key point about the Buffett deal is not that you should go out and buy Macquarie Bank or Babcock and Brown or other beaten down financials. None of us are going to get a deal like Buffett’s.

No. The key point is that it pays to have cash when the markets reach a turning point. If you know how to value assets and have the money to make a move, you’re in an enviable position. The question now is whether we really at that turning point. Probably not, is our answer from the Old Hat Factory.

While Buffett sinks his hooks into Goldman and its future commercial bank operations, we’ll focus on the net tangible assets that Buffett’s investment godfather Benjamin Graham valued so highly. Of course we’re talking about the resource sector here in Australia. More on that tomorrow.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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