Last week, Warren Buffett agreed to invest US$5 billion to acquire perpetual preferred stock (and receiving warrants to buy common stock at $115 per share) Goldman Sachs — one of the last remaining Wall Street investment banks. While commentators have literally fallen over themselves praising Buffett, the decision to invest in Goldman wasn’t supported by all. We noticed this percipient comment on the matter:
The banking business is no favorite of ours. When assets are twenty times equity — a common ratio in this industry — mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the “institutional imperative:” the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.
Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a “cheap” price. Instead, our only interest is in buying into well-managed banks at fair prices.
Despite its accuracy, those comments were not made in relation to the current crisis facing the banking sector. Rather, they were written by a younger Warren Buffett, back in 1990, shortly after Berkshire Hathaway acquired a large stake in Californian retail bank, Wells Fargo.
So, which Buffett got it right? The man who just invested US$5 billion in Goldman Sachs, or the banking skeptic of 1990? Or was the investment in Goldmans an example of buying a well-managed bank at a fair price?
Berkshire’s investment in Goldmans was on ostensibly very favorable terms, however, the deal is predicated on Goldmans surviving and thriving in the most difficult credit market since 1933. While the 10% yield on the preferred stock is nice, and certainly far superior to what other investors would receive, Buffett wouldn’t get out of bed for 10% — preferred or not (Berkshire’s compounded annual gain return over its lifetime is 21.1%). No, the kicker for Berkshire is the warrants which Buffett received which effectively allow Berkshire to acquire Goldman shares for $115 per share (they are currently trading at $129 per share amid the euphoria of Buffett’s “show of faith”).
Buffett knows a bit about investing in investment banks. One of Berkshire’s less than stellar acquisitions was that of a US$9 billion stake in Salomon Brothers in 1987. Buffett was eventually forced to become CEO of Salomon after a bond trading scandal. Buffett initially acquired convertible preferred stock (much like what he is receiving at Goldman) and while Berkshire eventually escaped from its Solly folly at a profit, Buffett himself noted that the investment decision was “very poor”.
Berkshire had a far more successful investment in Californian retail bank Wells Fargo, with its stake rising in value by around US$3billion since the initial purchase in 1990. However, there is a significant difference between buying a knock-down retail bank at the height of the savings and loan crisis, to purchasing a stake in the world’s leading investment bank during a credit crises.
Is Buffett’s investment in Goldmans more like his Salomon mishap or the Wells Fargo goldmine?
We think it is more Salomon. Goldmans does have a number of qualities that Buffett would usually seek, namely a dominant brand and strong management, giving it a protective moat of sorts. However, arguably the same could have been said for Salomon in 1987, when its trading desk (which featured the likes of John Meriwether) was legendary. Goldmans is a very different place to the firm which was built by Sidney Weinberg from 1930 until his death in 1969. In those days, Goldmans dealt almost purely as an adviser to leading US companies, a true investment banker. Since then, by necessity, Goldmans’ reliance on traditional advice fees has diminished, and it had drawn increasing revenue from proprietary trading.
It is often forgotten that in 1994, the bank actually made a loss from fixed income trading. The firm recovered and later, amid much internal consternation, floated on the New York Stock Exchange in 1999 (under the leadership of current Treasury Secretary, Hank Paulson). Since listing, Goldman’s earnings have skewed towards trading, away from advice. Last year, Goldman’s earned US$13.2 billion pre-tax from trading and principal investments. Goldmans’ other two divisions, traditional investment banking advice and asset management delivered only US$4.4 billion pre-tax.
Prop trading (which Goldmans has dominated in recent years) requires two major ingredients — an enormous amount of capital and a great deal of expertise. The credit crunch has greatly increased the cost of capital. Moreover, Goldman’s transition to an “ordinary” retail bank, and the need for it accept drastically higher regulation and reduced salaries will inevitably result in its best and brightest traders leaving the firm. Why would a superstar trader work at Goldmans in favour of a hedge fund? The expertise loss faced by Goldmans, the key to its brand, will be placed in serious jeopardy in coming years. Bankers are known for their intelligence not their altruism.
While Buffett’s purchase attributes a low value on Goldmans’ trading business, it is almost certain that the more resilient asset management and advice segments will also suffer significantly during any impending recession. If that happens, Buffett’s Goldman’s foray may resemble the Salomon mishap rather than his many investment successes.
Time will tell as to whether Buffett got this one right, but on its face, the investment appears most un-Buffett-like.
Crikey ed: Click on the link below to watch Warren Buffett talk about his recent GE buy and the bailout