Why Warren Buffett is Betting on Banks Now

Warren BuffettBank stocks could be the buy of a lifetime right now. The bailout is moving forward, the markets have stabilized, and Warren Buffett has put up a $5 billion bet on Goldman Sachs (NYSE:GS) this week.

Is it time to follow Buffett’s lead and go “all in” on banks now?

The answer is a simple no.

Buffett got a very sweet deal from Goldman that has reduced his risk, gave him a high degree of income, and didn’t eliminate a single cent of the potential profits from the deal. And there’s a little known way we get all that in our investments too. Let me explain.

There are a lot of reasons to like banks right now. Share values have been pummeled over the last year. If the bailout goes through, they’re about to unload their mistakes onto everyone else. The ones that are left still generate high fees, margins, and profits for the services they provide. And the ones that manage to survive will be some of the biggest winners when the U.S. economy recovers.

Banks are an extreme value play that undoubtedly caught Buffett’s eye. However, even he needed some enticing odds to make a bet this big.

As individual investors, we can’t simply follow his lead here and buy Goldman Sachs. Buffett was afforded a few special advantages that aren’t usually available to the rest of us. But as we’ll see in a moment, occasionally we can get these advantages too.

You see, Warren Buffett didn’t make a simple $5 billion investment into common shares of Goldman Sachs. Anyone can do that with a few mouse clicks or a quick phone call to his or her broker. He got a lot more for his $5 billion.

Berkshire Hathaway acquired special perpetual preferred shares of Goldman Sachs. These aren’t the shares you can buy on the NYSE. The preferred shares Goldman issued to Berkshire have all kinds of special attributes usually reserved for high-net worth individuals.

Goldman’s perpetual preferred shares carry a 10% annual yield. That’s eight times higher than the meager (if sustainable) 1.1% yield offered by Goldman’s common shares.

In addition, Goldman issued warrants as part of the deal. Warrants are similar to stock options. They give you the right to buy shares at a preset price, but not the obligation. In this case, Berkshire walked away with more than 43.4 million warrants to buy Goldman shares for $115 (currently trading at $132).

Now, there’s usually a drawback to preferred shares. They have higher yields, but the upside is usually limited. They don’t rise in value with common stock and they don’t usually go down with it either.

Preferred shares are good investments if you’re looking for high income. But they don’t offer the growth upside of common stock. Sure a 10% yield is attractive, but it’s not enough to offset the risks in this case. After all, if Goldman goes belly up the preferred shares will be worthless.

This structure of investment is a very good one from Buffett’s perspective. It allows Buffett to collect 10% per year on his investment. Since the shares are preferred, there is little chance of them falling as long as the dividends are paid.

Most importantly, Buffet will make a killing if Goldman’s shares rise. If they hit $230 (which is still 8% below the 52-week high), Berkshire will have turned a $5 billion profit on its investment all the while collecting $500 million a year in dividends. That’s the beauty of an investment structured like this.

Quite frankly, there aren’t many better deals than one that offers high income, reduced downside, and plenty of upside. As you can imagine, these types of deals are usually scooped up by big institutional investors. But you don’t have to be Warren Buffett or an investment manager that can throw hundreds of millions of dollars at a company to get your hands on these types of opportunities that only convertible securities can offer.

All too often, I see individual investors simply pass on convertible securities. Sure they might be a little bit more complicated than simply buying and selling stocks, but they’re some of the best investments you can make. In fact, their unique qualities make them even better during market downturns.

One of my favorite examples is Crown Castle International Convertible Preferred (OTCBB:CCIKO).

These are the preferred shares of Crown Castle International (NYSE:CCI) which can be converted into common shares.

Crown is one of the world’s leading cell phone tower owners in the world. The company owns more than 22,000 towers in the United States and 1,400 towers in Australia. It leases and rents these towers to deep-pocketed customers like AT&T, Sprint, and Verizon. In fact, 66% of Crown Castle’s cell towers are leased to AT&T and have towers in 91 of the top 100 U.S. markets. In a way Crown gets a small piece of the billions of dollars spent on cell phone usage each year. And the company is a veritable cash machine.

Cash flow from operations has been steadily climbing over the past couple of years as the company bought more and more towers and ratchets up the rent. The tower business has been a very good one.

But it’s expensive. Crown has to pay to build all those towers. All of those big up-front costs soak up a lot of cash. As a result of that and a couple of takeovers over the years, Crown has had to turn to outside investors for additional capital. In Crown’s case the additional capital was for justifiable expansion, not for life support. And Crown had to give the big money investors that could chip in a few million dollars what they wanted.

Crown Castle attracted capital by issuing these convertible preferred shares. These shares, which currently trade for around $48 a piece, pay out $3.14 in dividends per year (good for a yield of 6.5%), and can be converted into regular shares of Crown Castle at $36.87.

Crown Castle’s common shares currently trade around $32, so the conversion option isn’t worth much, but if they go for a run the preferred shares will run up right along with them. If not, you’ll still get a 6.5% yield while you wait.

Of course there are a lot of other considerations to make with Crown Castle Preferred shares. These shares don’t trade very much. And buying or selling a big position would have some impact on the market.

There are a lot of unanswered questions. What’s the upside with the common shares? Will there be enough cash flow to cover the dividend five years from now? What will be the impact of an economic downturn on rental and lease revenues? And that’s just to start off before we really started delving in.

However, we can take one valuable lesson away from all this. Convertible securities (preferred shares, bonds, debentures, etc.) can be some of the best investments you can make. In the right instances, they offer high income, less downside risk, and all the upside of a stock.

Convertible securities put the odds of success in your favor. At first glance, Warren Buffett might seem to be taking big swings here. But he’s actually reducing the risk as much as possible and setting himself up for either a win…or a big win.

And that’s how successful investors invest.

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