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I was reading an article in today's Wall Street Journal by Shira Ovide titled "Warren Buffett Is $1.5 Billion Underwater on His Bank of America (BAC) Stock." Here's a quote from the article:

Bank of America's stock price just broke into the embarrassing sub-$5 stock basement. Somewhere in Omaha, alarm bells are going off? Yes, Bank of America's stock swoon is dragging down America's wisest investor, Warren Buffett, who now is about $1.5 billion underwater on his BofA common-stock warrants…But Buffett's cherry atop his BofA sundae was warrants that allow him to buy 700 million Bank of America shares at a strike price of about $7.14 a share. $7.14 a share. Ouch. BofA shares are now at $4.94.

As if an afterthought, Ovide mentions that "Buffett's warrants may be exercised in whole or in part in the 10 years following the closing of the deal, so he can afford to be very patient with Bank of America's stock price. But Buffett already is waiting out his other crisis investments, too." Ovide finishes up the article by mentioning that Buffett is down 25% to date on his Goldman Sachs (GS) warrants.

The best way to analyze articles like these are by asking two questions-first, what does this really mean for Warren Buffett and shareholders of Berkshire Hathaway (BRK.A)? And secondly, what can we, as everyday potential investors, take away from it?

First of all, from a Berkshire perspective, the deal with Bank of America has, and will continue to, mint money for Berkshire shareholders. To date, Buffett has not bought one single common share of BAC stock. When Buffett made his August investment, Bank of America created a special classification of preferred shares, and issued Berkshire 50,000 shares of this preferred BAC stock, valuated at $100,000 per share, which constitutes the $5 billion investment in Bank of America that most of the headlines blare. The terms of these preferred shares for Buffett is that Bank of America will pay Berkshire Hathaway 6% annually, or $300 million per year in interest, indefinitely until Bank of America decides to return the $5 billion to Berkshire, at which point it will have to pay an additional 5% premium, or $250 million, to Berkshire as part of the closing terms of the deal.

If we separate Buffett's investment into two conceptual parts, that 6% annual return of $300 million to Berkshire represents the predictable part of Buffett's investment that will pay Berkshire $300 each year indefinitely-as long as Bank of America does not go bankrupt. And even if Bank of America did go bankrupt in the next few years, by virtue of owning preferred shares, Buffett would stand in line to collect before the common shareholders.

Which brings us to the icing on top of Buffett's investment-the Bank of America warrants. The fact that Buffett has a decade -10 years! - to exercise these warrants makes it seem absolutely ridiculous to run headlines about how he is "billions underwater" based on the price of the stock only six months later. Buffett has until 2021 for Bank of America to get above the $7.14 per share strike price. Running headlines like this about Buffett being underwater gives the impression that he has made a bad investment, which does not accurately reflect the terms of the deal struck. The realistic worst-case scenario for Buffett is that he has to content himself with 6% annual returns from Bank of America until the bank ends the agreement (which is probably a realistic worst-case scenario a lot of wouldn't mind having with our investments), but the 700,000,000 shares in stock warrants ensure that if Bank of America can recover within the next 10 years to even the price point of $19 it was at last year, then Buffett will make additional billions. If you try to judge Buffett on this investment only six months in, you're going to miss the big picture of how Buffett could make quite a lot of money on this deal, all while reducing most of the risk that average investors would assume by merely buying the common shares of the company.

And this, of course, brings us to the final point-the consequence of this type of story for investors. How often do you see a headline report a Buffett investment - be it the preferred shares of General Electric (GE), the special warrants as part of the Goldman Sachs deal, or this recent Bank of America investment - and then the conversation turns to whether we, as investors working on a different plane, should go and purchase shares of that very company. I understand why the temptation to follow Buffett is there - he has the best long-term track record of any investor alive today, and his reputation for buy-and-hold investments adds a certain appeal for investors looking to park money somewhere - but the debate is necessarily flawed because Buffett is not operating on the same plane as us when he is not buying common shares in a company.

Buffett bought preferred shares of BAC that pay 6% annually, attached with a sweet warrant option that he can wait a decade to exercise - that is in no way similar to investors who go out and buy common shares of the stock based on the news of Buffett's purchase. The terms of Warren's deal give him far less downside and far more upside than what common shareholders get, so the comparison between the two isn't valid. The only thing we can glean about Buffett's preferred investments (in terms of a vote of confidence) is that he most likely doesn't think the company he is putting money into is at risk of bankruptcy in the foreseeable future.

But still, if you want to build a portfolio that mirrors Buffett's - make sure you make an apples to apples comparison and look to the common stocks he has been buying this year - companies like Wells Fargo (WFC) and IBM (IBM), instead of the preferred deals he makes that give him substantially better terms than anything you or I could get. When we look to emulate Buffett, we should make sure that we only do it when he is assuming the same risk and return scenario with his investments as we are.

Source: Warren Buffett's Investment In Bank Of America Is Doing Just Fine