Breaking Down Warren Buffett’s Offer

Last night, Warren Buffett announced that Berkshire Hathaway (BRK-A) is buying $5 billion of a 10% perpetual preferred issue in Goldman Sachs (GS). The preferred is callable at any time by Goldman for a 10% premium.

As a sweetener, Buffett will get warrants to buy $5 billion of GS common at $115 per share. That works out to be about 42 million shares. The warrants are exercisable for five years. GS stock popped on the news (it also was up sharply just before the end of trading yesterday, as the rest of the market — particularly financial names — were falling apart, so the SEC should be looking to see if the news leaked and someone was trading on inside info), and is now trading up $5 per share, to $130.

At these levels, those warrants are worth about $2 billion. Thus the net cost to Buffett is about $3 billion. Given that he will be getting $500 million a year in dividends, at a net cost of $3 billion, that works out to a yield of 16.7% per year.

Since it is a preferred issue, rather than a debt issue, it means that GS will be paying the dividends with after-tax dollars. This is extremely expensive financing for GS. However, Buffett is attacking the problem of too much leverage from the right direction, by adding to the equity base, rather than simply buying assets to reduce the leverage (assets/equity). There is simply far more bang for the buck that way. This is a rather important difference from what Secretary Paulson is proposing that the U.S. Government do.

I am still wary of investing in the Financial sector (you will not get anywhere near as sweet a deal as Warren will). For a conservative investor, TIPS (inflation protected Treasury notes) look like an excellent place to hide out until this storm passes. These are just about the only investments I can think of that are protected both from the treat of deflation, which is what will occur if we have the uncontrolled financial meltdown, and from the threat of much higher inflation, which is a distinct threat given that the Fed is desperately trying to create money out of thin air to offset the
deflationary risk.

They are not, however, entirely risk-free, since they would be hurt by a rise in real interest rates. Given the increased demand for capital by the U.S. Government, that is a real possibility.

Within your stock portfolio, think defensively. Consumer Staples and Health Care firms with strong balance sheets fit the bill. Think about companies like Bristol Myers (BMY) and Abbott Labs (ABT) or Unilever (UN), Hershey (HSY), Kraft (KFT) and Kimberly Clark (KMB).

The big International Oil companies like Exxon (XOM), Chevron (CVX), Conoco (COP) and British Petroleum (BP) also look like good safe harbors in the storm.

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