Buffett invests in GE...should we smile or frown?

You've got to hand it to him, Warren Buffett knows how to make a splash.

Last week, the world's greatest value investor stepped into the maelstrom and invested $5B in Goldman Sachs. At the time, a lot of us wondered whether Buffett's move would calm the markets -- it hasn't. Tomorrow we'll get another chance to see if the Oracle of Omaha's confidence in bellwether U.S. equities will help stem the tide of investor uncertainty.

That's because today Warren Buffett invested $3B in General Electric. The terms were similar to those he received from Goldman Sachs:

• Berkshire will invest $3B in exchange for perpetual preferred stock that pays a 10% annual dividend
• Berkshire will receive rights to purchase an additional $3B in common stock at $22.25 per share, exercisable for the next 5 years
• GE will raise an additional $12B in common stock through a spot secondary [pricing tonight]
• GE can call in the preferred stock at any time over the next three years for a 10% premium

In discussing the deal, Buffett spoke of the opportunities he's seeing in the equity markets as well as GE's stature as an American institution:

"Frankly these markets are offering opportunities that weren't available six months or a year ago," Buffett said in an interview on CNBC. "So we're putting money to work."

"GE is the symbol of American business to the world. I am confident that GE will continue to be successful in the years to come."

So should investors look at Buffett's actions enthusiastically as a sign that it's safe to get back in the water OR are his investments actually cause for concern and indicative of just how serious the credit crisis has become?

The Bull Case -- Buffett is putting money to work

Buffett has invested $8B in the last week in two respected U.S. domiciled companies. Both are on the SEC's no-short list and both have suffered difficult times and lagging stock prices. Many people have made a career out of following in Buffett's footsteps, and there is unquestionably a symbolic component to seeing him put Berkshire's capital to work at a time when so few investors are willing to commit.

Mike O'Rourke, the Chief Market Strategist for Baypoint Trading (BTIG) summed up the bullish side of Buffett's actions in his nightly newsletter:

Once again, we find the cynicism surrounding another Buffett investment stunning.  For twenty years, market participants clamored to follow Buffett into any transaction, and now that he is finally putting money to work, the common response is that companies are giving him too much. In a capital constrained world, if you can get Buffett’s capital, you are well ahead of the competition.

The Bear Case -- Buffett is naming his terms, and they're not cheap

10% perpetual preferred plus warrants = hardly the same as going out and buying common shares in the open market. Buffett is no altruist, he and his investors expect him to act aggressively when opportunity arises. He's getting extremely attractive terms because GE and Goldman Sachs feel those terms are warranted; and there's the rub. GE is an American institution and carries a AAA credit rating. The fact a AAA-rated firm of GE's caliber would feel compelled to offer a senior perpetual preferred to any investor, even Warren Buffett, is a testament to just how tight liquidity remains throughout the system. To take a page out of my friend Roger's book...companies are paying a premium for option liquidity.

So is Buffett signaling a market bottom? Impossible to say. Buffett doesn't need the equity markets to rally for his investments to pay off. He just needs GE and Goldman Sachs to stay solvent and pay him 10% dividends year in, year out. Furthermore, Buffett is telling anyone who listens just how tenuous a situation the capital markets are in and the necessity of a bail out and then a lot of hard, smart decisions to follow.

One last point...To be a truly great value investor you have to zig while others zag. You have to be willing to put capital to work in an area where most won't. That's why great value investors pounce during periods of extreme sentiment. Buffett has the benefit of hindsight, great instincts and, most importantly, an ability to be patient in a market that, by definition, favors impatience. Stock prices are quoted in the blink of an eye, returns are followed in real time, funds are put to work and redeemed based on what happens over the course of days, weeks and months. To make money the Buffett way, you have to be willing to forgo all of that and treat equity stakes as though they were private investments with long-term horizons. That's MUCH easier said than done. Most public equity investors, particularly those running hedge fund money, are compensated [and rebuked] based on what they do in shorter time intervals. Buffett doesn't need to worry about that; if Berkshire Hathaway's stock were to meander for years, it wouldn't change his functional wealth, his buying power, or his reputation.

Disclaimer: At the time of writing, neither the author nor the firms affiliated with the author maintained an position, long or short, in the publicly traded companies mentioned or any related instruments. The author and the firm reserve the right to alter their investment positions at any time in the future. The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Comments

[Jason Wood]

Watch out everyone, I finally have my partner and buddy Monty posting on the blog!

Monty, agreed 100%. Today's price action broadly (and the GE stock price movement post secondary) I think speaks to how none of us can look at Buffett's dealings and take them as any indication of what we should be doing.

Talk to you tomorrow; can we somehow get the SEC to suspend trading on Fridays? I used to like Fridays. :)

[Monty]

Jason - I agree with your analysis from Buffett's perspective and in terms of the broader market for the most part. A 10% guaranteed return (assuming GE continues to be credit worthy) and getting a call essentially for free, what's not to like? If GE for some reason isn't money good, we all have problems.

It is challenging to view Buffett's investment as a means of being bullish on the broader market. That is not to say the market won't rally from just that this investment is not a reason.

I look at this from a return on capital versus cost of capital perspective. How does GE earn an acceptable rate of return on 10% debt plus warrants, which brings its pre-tax cost of capital to the mid-teens level? According to ValueLine, GE's return on capital has ranged from 6.4% to 7.4% from 2002-2007. (admittedly, this is simplistic analysis, and there are many variables to examine in order to measure the true cost of capital on a fully taxed basis).

Thus, it is difficult to view the transaction with an optimistic view from the GE shareholder perspective since it is likely that GE will not earn an adequate return. More likely as you noted, GE will call-in the pfd in a few years, which makes this an expensive bridge.

If GE has to resort to an exorbitant cost of capital for essentially a medium term loan, what is (or isn't) the implication for the 99% of the S&P 1500 companies that aren't AAA rated?

[Monty]

Jason - I agree with your analysis from Buffett's perspective and in terms of the broader market for the most part. A 10% guaranteed return (assuming GE continues to be credit worthy) and getting a call essentially for free, what's not to like? If GE for some reason isn't money good, we all have problems.

It is challenging to view Buffett's investment as a means of being bullish on the broader market. That is not to say the market won't rally from just that this investment is not a reason.

I look at this from a return on capital versus cost of capital perspective. How does GE earn an acceptable rate of return on 10% debt plus warrants, which brings its pre-tax cost of capital to the mid-teens level? According to ValueLine, GE's return on capital has ranged from 6.4% to 7.4% from 2002-2007. (admittedly, this is simplistic analysis, and there are many variables to examine in order to measure the true cost of capital on a fully taxed basis).

Thus, it is difficult to view the transaction with an optimistic view from the GE shareholder perspective since it is likely that GE will not earn an adequate. More likely as you noted, GE will call-in the pfd in a few years, which makes this an expensive bridge.

If GE has to resort to an exorbitant cost of capital for essentially a medium term loan, what is (or isn't) the implication for the 99% of the S&P 1500 companies that aren't AAA rated?

[Jason Wood]

Jeff...I think the actions are more symbolically bullish than tangibly so. GE is getting optionality but at a price no AAA-rated company should ever have to pay. This was a smart move for Buffett no matter what [as long as GE doesn't go under], and I think it will be seen as a smart move by GE if they call in the preferred in a few years b/c the system is back on normal footing. But too early for me to view it as a bullish signal for public equity investors.

[Andrew Abraham]

We have been discussing on our forum Buffetts purchase of Goldman and now GE... I think he is following in the steps of Ben Graham...What am I missing... You have stated both cases... can you further elaborate for our community...

[Jeff]

Buffet's funding of GE is a great example of the disintermediation of the banking system. If the banking system can't figure out how to provide liquidity, a new source will be found for the strong borrowers (GE). I think we see more non-traditional capital providers, such as private equity, filling voids that banks used to fill. I enjoyed the post. It's a Bull Case for me.