Inside Buffett's deal for Goldman

Inside Buffett's deal for Goldman... Poor Boone Pickens... Zell sees a recession... More about Enron's, err, Goldman's books... Real mark-to-market accounting... Want a job?...

Last night, Warren Buffett announced Berkshire Hathaway (his holding company) would take a $5 billion position in Goldman Sachs. Before you rush out to buy Goldman's stock, 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.

What's Buffett's risk? Well, thanks to the government bailout, he probably doesn't face any. Buffett said he wouldn't have purchased Goldman unless he was sure Congress would do the "right thing" by approving the $700 billion bailout. The right thing for whom?

I've watched Buffett carefully for nearly 15 years. And this is probably the best deal I've ever seen him get, which tells me Goldman was in even worse shape than I'd imagined. (See our discussion of this in the mailbag, below.) As Buffett proves time and time again, there are big advantages to holding cash and waiting for inflection points in the market. Too bad I can't make a living publishing an investment newsletter that only makes stock picks once every 10 years or so. It would be the best investment letter you could buy.

This is Buffett's third big purchase in the past two weeks – definitely a sign of a bottom in stocks. (He also bought utility company Constellation Energy and Japanese toolmaker Tungaloy.) Last Friday, Dan Ferris told readers Berkshire Hathaway was his No. 1, safest pick right now... And we're currently seeing why. Buffett is able to make deals no other investor can. Try calling Goldman and asking for preferred shares with a 10% coupon and free warrants.

Japanese bank Sumitomo Mitsui Financial Group is considering investing in Goldman alongside Buffett. If it does, Japanese companies will own large chunks in Goldman, Morgan Stanley, and Lehman. Between the Japanese, the Chinese, and the Saudis, there's not going to be much of America they don't own. Don't worry – just remember what ol' Dick Cheney said a few years ago, deficits don't matter.

Buffett's thriving in this market, but fellow billionaire T. Boone Pickens is getting crushed. Apparently his "Pickens Plan" energy campaign and new book, The First Billion Is the Hardest, have sidetracked the oilman... One of his energy hedge funds is down nearly 30% for the year. In total, his funds have lost $1 billion – Pickens is personally down $270 million. "It's my toughest run in 10 years," he says. "We missed the turn in the market, there's nothing fun about it."

Too bad Pickens doesn't have a bunch of former associates in power at the Treasury, like Goldman does. Why not bail out the oil speculators, too? Don't we need cheaper gas?

Yet another billionaire, real estate tycoon Sam Zell, is predicting we'll enter a recession next year. But he does think the single-family housing market is close to a bottom.

Zell, nicknamed the Grave Dancer for buying distressed commercial property in the '90s, said office buildings that aren't top quality or located in downtown areas will see a long, slow downward spiral. The commercial real estate slump has led to less construction, and "if there is no new supply, then high-quality well-located prime real estate can only be terrific," said Zell.

We may soon get a reference price for "prime" commercial real estate. AIG may sell its $16 billion global real estate portfolio to raise cash – it owns 2 million square feet in downtown Manhattan alone.

New highs: none.

In the mailbag, a subscriber raises questions about my criticism of Goldman's accounting. What questions do you have? Ask us anything, here: feedback@stansberryresearch.com.

"You wrote: Goldman's trading activities have burned through a tremendous amount of cash, funded by huge and ever-increasing amounts of borrowed money. And while the firm has reported profits year after year, its cash-flow statements show only soaring losses.

"I spoke to a friend familiar with Goldman who told me that the operating cash flow is negative because the gains in net income are non-cash until they are realized. Therefore the positive net income is reversed by negative adjustments on the cash flow statement. These are then offset by cash inflow from debt. Cash flow is just a function of how debt is managed. The business seems to support the leverage. Goldman reported over $25bn of net income for the last three years. Their books are marked to market, meaning that if they have paper losses, those losses have to run through the income statement. They have been increasing debt because they believe they have been able to support more leverage with all of the retained earnings from their net income. Your statement above seems to misread the cash flow statement, and doesn't acknowledge mark-to-market accounting that would expose big paper losses if they existed. Instead, he told me, Goldman has big paper gains, that they have not yet realized. The key is to look at their book value, which has been steadily increasing. I wonder what you think of this perspective? Thank you." – Paid-up subscriber Daniel Feinberg

Porter comment: This is precisely the argument Enron used to explain its accounting too. It said the same thing, almost word for word.

In mark-to-market accounting, you take credit for an asset's price gain before you sell it. So you can legitimately use it only if there is a ready market for the asset in question, if the asset's price is conservatively discounted to account for market risk, and if such assets are in fact routinely sold.

However, at Enron and now at Goldman, none of these factors are present. There is no ready market for billions of Goldman's derivative assets. Prices for much of Goldman's asset base cannot be determined except by management "estimates." And most importantly, the assets in question are not routinely sold. Thus, just as at Enron, Goldman's demand for additional debt continuously expands and will some day cause the firm to collapse. Lenders will suddenly refuse to extend credit because Goldman's assets cannot be sold for anything like what they've been "estimated" to be worth. (And that's what happened, finally, last week.)

If Goldman's accounting were accurate, you wouldn't see such huge discrepancies between cash flows and net income year after year. Eventually, investments would be sold and the profits Goldman had been claiming would appear as cash. But they never materialized. They never will. Goldman, for the last three years at least, has been operating like a gambling addict, borrowing more money from its bookies and doubling down on its bets in a desperate attempt to get out of the hole.

Nobody with anything like the profits Goldman has claimed would allow Buffett to buy up to 10% of their company for $1.8 billion in real exposure. That's about a 90% discount to the value of the company just three months ago. Buffett's price is a much more accurate estimate of Goldman's intrinsic value than any so-called "book value." What was Bear Stearns' book value when it went bankrupt? Over $50 per share. How about Lehman's? Over $15 per share. The accounting is all nonsense. If you want to see a real mark-to-market number, look at Buffett's offer to Goldman this week. Or remember what I bid to takeover Lehman: $1.

"First of all, my mom is an S&A Alliance member, and showed me to your site last Spring. Since then, I've kept up with most of your team's publications and the daily Digest, and I just wanted to say you all do a fantastic job. As a college student usually focused on making the next tuition payment, I don't have much money left to invest, but I enjoy reading your publications and seeing the ways in which you approach investing. Keep up the good work!

"Secondly, do you have any job openings? I am a graduating senior at Notre Dame and I'm applying for jobs. I was never really interested in investment banking, and I thought working at a prestigious buy-side firm would be cool, until I spoke with a friend who works at Citadel and decided maybe that wasn't what I wanted either. I would really enjoy doing investment or economic research, and if you guys needed someone at the office, I would love to speak with you (or someone from your firm) about working at S&A. My GPA isn't exactly a 4.0, but that has more to do with the fact that I had already passed out of many first- and second-year requirements when I got to college, and couldn't get into most of the finance classes I wanted because I was too young – stupid bureaucracy.

"Once I got into the finance, accounting and economics classes I was a star. I understood the material better and scored higher than pretty much everyone in most classes, often being a year younger than the rest of the students. I have what you might consider 'being the poorest kid on a rich block' syndrome, and tend to be pretty motivated. Anyways, if you have any openings around the office you think might be good for someone like me, or have any general ideas you would care to share about careers in finance, I would be all ears. Thanks!" – Paid-up subscriber's son Patrick B

Porter comment: I applaud your action, Patrick. It's the second-best way to get the job you want. The best way? Offer to work for free. One more suggestion... Don't waste time talking about what you did or didn't do in college. No one cares.

What we care about, like any other employer, is what you are willing and able to do for us now. What skills do you have? Can you use a Bloomberg terminal quickly? Can you make an Excel spreadsheet dance? How familiar are you with poker and other forms of logical gambling? How many stocks have you purchased on your own account? How familiar are you with the SEC's database? How many different types of businesses do you know well? How many newsletters have you read in the past? How many investment books have you read? Which ones did you like? How much pay (or rather, how little pay) are you willing to accept for an opportunity to work with us?

What will you do the first time someone ridicules your work in public and bets you $10,000 you're completely wrong? I've seen Doug Casey do this to a rookie analyst. Our work place, like most in the financial industry, is ruthless.

"I have a simple question that may be on the minds of many. Why buy bonds now, when your entire portfolio of newsletters is about stocks and stocks alone? It seems you have suckered many individuals into buying stocks when they should have been in bonds all along. Even the writer of the newsletter True Income is saying that only fools would ever invest in the stock market. This seems to run counter to the entire thrust of your company, even your own newsletter of PSIA, with the recent MBIA recommendation." – Paid-up subscriber D.R.

Porter comment: Normally, you'll make more money in stocks than in bonds. Even when you're "suckered" into buying them. But from time to time, the bond market goes haywire, and you're offered the opportunity to make huge gains from these relatively safe investments. Now happens to be one of those times. Also, as we've written many times, if you're over the age of 50 and approaching retirement, bonds should probably make up most of your portfolio.

Regards,

Porter Stansberry

Hatteras, North Carolina

September 24, 2008

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