Buffett's Bet Opens Doors for Investors

 | Aug 25, 2011 | 10:55 AM EDT
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The past 24 hours have been a whirlwind of surprises for investors. Last night, the iconic Steve Jobs resigned his post as CEO of Apple (AAPL) and is assuming the helm of chairman. After falling over 5% on the news, Apple shares are down roughly 2%. My selfish capitalistic ways were hoping for a major drop in hopes of getting a chance to nibble on one of the world's most innovative consumer products companies.

Investors got some more news this morning and this one is ripe for the picking. Warren Buffett rode in like a white knight again, investing $5 billion in Bank of America (BAC). The deal was reminiscent of his investments in Goldman Sachs (GS) and General Electric (GE) at the height of the financial crisis more than two years ago. What makes Buffett's bet very intriguing is that he was likely approached by BofA back in 2009 and refused. Today he ponied up $5 billion. Why?

Timing is Everything

Buffett is no fool. Years ago BofA was in much more dire straits than today. BofA is now the blood of the U.S financial market, whether you like it or not. The U.S financial system is intricately tied to BofA. BofA holds about $1 trillion in consumer deposits and its network of businesses serves one out of every two American households. For Buffett, it was all about timing, which is valuable in investing, because it's often impossible.

Within the past month, BofA shares collapsed from $9.50 to around $6 a share. At that price the company was being valued $60 billion. Alone, BofA Merrill Lynch earned more than $5 billion in 2010, so that business alone at 11x earnings was worth $60 billion. Everything else -- the deposits, the private wealth management business, the equity investment in China Construction Bank, and yes the mortgages -- were free.

The major uncertainty surrounding BofA was the possibility of an additional capital raise. Buffett has solved that issue. And I would wager pennies to peanuts that he only invested after he became comfortable with the balance sheet. When he invested in Goldman, he took preferred stock paying 10%. With BofA he is taking preferred with 6%. His real big payoff will come from the equity kicker that Buffett always insists on, in this case warrants to buy 700 million shares at $7.14 a share, exercisable at any time for 10 years.

With BofA trading above $8, Buffett has already netted $700 million on paper. Unlike individual investors who are taking a risk owning BofA stock, Buffett's deal is guaranteed to make him money. Yet even when all is said and done, investors may wish to participate in owing the equity. Headlines are quick to point out how bad of a deal this was for BofA. The preferred will cost them $300 million per year (yet the company can redeem all the preferred at any time for $250 million). But given the fact that the core business can earn over $10 billion in profits, the cost is manageable. The warrants, if exercised, would only dilute shares outstanding by 7%.

If BofA indeed needed to raise capital, better from a capitalist than the U.S government. An investment from Buffett shows that he sees some huge potential upside from the equity. While he gets $300 million a year on the preferred, he will stand to make many billions from the stock price appreciation. And remember that BofA can decide next week to pay him $250 million and retire the preferred (plus the $5 billion Buffett loaned of course); Buffett wants to own the stock.

For long-term investors, they may want to own the stock too. Noted value investor Bruce Berkowitz owns about $1 billion of BAC shares at prices above today's price. I've yet to find any comments from Berkowitz on Buffett's deal. But both Buffett and Berkowitz have a history of making tons of money by patiently investing in financials. Investors with the same time horizon have a rare chance to participate alongside the pros and reap the potential payoff.

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