In August, 2011, Warren Buffett decided to make an investment in Bank of America
ID: 2692441 • Letter: I
Question
In August, 2011, Warren Buffett decided to make an investment in Bank of America by purchasing a large amount of preferred stock. The terms of the investment were that Bank of America would pay Buffett a fixed dividend of $300 million every year and that the investment would last indefinitely. (Because the transaction had no maturity or end date, it can be considered a perpetuity.) In prior deals with General Electric and Goldman Sachs, Buffett had demanded a 10% rate of return. If he had wanted to achieve a 10% rate of return on his Bank of America investment, how much would he have paid for the Bank of America preferred stock? (Note that 10% was not the actual rate Buffett used for this transaction; weExplanation / Answer
To borrow an oft-repeated quote from Apple (AAPL) co-founder Steve Jobs, the only man who managed to eclipse Warren Buffett at the top of this week’s financial headlines, “It is important to remember that sometimes, what you don’t do is more telling than what you actually do.” Warren Buffett’s big announcement that he is investing $5 billion into Bank of America (BAC) has gotten all the talking heads and financial analysts talking about whether or not now is the time to buy Bank of America shares. But while everyone is talking about Bank of America’s common stock, we should keep in mind that, in fact, Buffett has not yet bought BAC’s common stock. Here are the terms of Buffett’s deal with Bank of America: Bank of America created a special type of preferred stock by issuing Buffett’s Berkshire Hathaway (BRK.A) 50,000 shares of the preferred classification, valued at $100,000 per share, for a total of $5 billion. This preferred stock will pay Berkshire 6% annually in perpetuity. Should Bank of America want to end the arrangement, they will have to pay Berkshire a 5% premium of $250 million. And of course, should Bank of America ever go bankrupt, the shares of the preferred stock would stand in line ahead of the common shareholders to redeem the liquidated assets. And of course, the deal includes the clause that really sweetens the pot for Berkshire Hathaway. Buffett gets warrants to buy up to 700,000,000 Bank of America shares for the price of $7.14 per share. And get this — Buffett gets up to ten years to decide on whether he wants to buy the shares. That’s a pretty sweetheart deal for shareholders of Berkshire Hathaway, and it could be quite dilutive for current shareholders of BAC. Right now, there are a little over 10,000,000,000 shares of BAC stock. If Buffett exercises 700,000,000 warrants, then Bank of America shareholders will experience a roughly 7% share dilution. Let’s say, hypothetically, that Bank of America generates earnings per share of $2.00 in the year 2014. If Buffett exercises those warrants, he will singlehandedly reduce your share of profits to $1.86 per share. In a twisted way, Buffett’s so-called vote of confidence in the bank could actually prove harmful to shareholders of the common stock a couple years down the road. The bottom line is that Buffett’s decision doesn’t tell us that now would be the time to buy Bank of America’s shares, nor does it tell us that now would be a good time to sell BAC shares. But, we do know that Buffett, like everyone else, had the opportunity to buy shares of common stock, and chose not to. Of course, when you can get preferred shares that yield 6% annually and the opportunity to purchase shares at $7.14 over the next 10 years, it would be foolish of Buffett to pay for the common stock when he could get a much more attractive offer, like the one that he secured with Bank of America's CEO Brian Moynihan. Investors who attempted to follow Buffett by buying the shares of General Electric (GE) and Goldman Sachs (GS) in 2008 would still be underwater by over 20+ percent, while Buffett has managed to make billions off of his deals with the two firms. There is no reason to assume that will be the case for current shareholders of BAC’s common stock, but it does offer an illuminating illustration of what can happen when Buffett initiates an investment on a much higher plane than us mere mortals. Buffett has structured his deal to eliminate quite a lot of the downside while accelerating the upside due to the warrants, and potential investors would do well to keep this discrepancy in mind before sending in a BAC buy order.