Warren Buffett Knows the Language of Investing
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Should You Stay Invested in Financial Stocks?
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Should You Stay Invested in Financial Stocks?
By: Sara Nunnally
Posted: May 03, 2011
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Warren Buffett held a press conference on Saturday in Omaha, Neb. He answered questions about the trading scandal with David Sokol and Lubrizol. The public has been really focused on this story.
No surprise, really. David Sokol was on the short list of people who could take over for Buffett when he retires.
But there was another announcement that might be more important to investors.
It was about the billion investment he made in Goldman Sachs (GS:NYSE) during the financial crisis. Buffett bought stock warrants, which are kind of like options. These warrants expire in 2013, and Buffett said his company will be holding those warrants almost until they expire.
Before we get into why, let me explain some of the nuts and bolts of what stock warrants are and how they work.
What Is the difference between a Stock Warrant and a Call Option?
A stock warrant is just like a call option. A warrant or call option will give you the right to buy a financial stock at a certain price by a certain date. Buying either a warrant or call option means that you think the financial stock’s share price will go higher.
The main difference between a stock warrant and a call option is that warrants are issued by the company, while options aren’t. That means that stock warrants are also guaranteed by the company.
Companies, like Goldman Sachs in this case, will issue stock warrants to help fund some of its debt.
Let’s move on…
The stock warrants that Buffett bought have a “strike price” of 5. This means that he can buy shares of Goldman Sachs at 5… no matter what price the financial stock is actually trading at.
On Friday, Goldman Sachs closed above 1. If Buffett were to exercise his warrants, meaning “cashing in” his warrants for shares of the company, he would immediately have a profit on every share of stock. That’s an instant gain of more than 31%.
But Buffett says he’s holding his warrants.
He’s betting that Goldman Sach’s share price will continue to increase.
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(Investing doesn’t have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Jared Levy simplify the stock market for you with our easy-to-understand investment articles.)
Less Profitable Banks than Goldman Sachs…
That’s why I found it a little confusing when he said at the same press conference that some banks will be less profitable in the future. He said, “U.S. banking profitability will be considerably less in my view in the period ahead than it was in the early part of this century.”
This could be because banks will probably be deleveraging. Most companies deleverage by getting rid of excessive debt. Debt can be risky, so companies that are trying to deleverage might be in danger of defaulting.
Also, paying down debt eats into profits. Share prices could suffer, even though companies might be doing the right thing by paying their debts.
So why is Buffett holding his Goldman Sachs warrants instead of taking a huge 31% gain?
A Question of Timing
It may just be a question of timing. Some big banks have seen some harsh first quarters. In fact, Bloomberg reports:
Revenue at six of the largest U.S. banks declined by the biggest percentage in three years in the first quarter, as lending dropped and fees were reduced. With unemployment stuck above 8 percent, housing prices falling again and restrictions on charges, the banks are underperforming the broader market.
At the same time, banks have been reducing loan losses.
What this means is that banks might not be a good investment right today, but they will be a year from now. Buffett’s explanation? “Banks periodically go crazy. It’s always on the asset side.”
Here’s how the KBW Bank Index of the 24 biggest lenders in the U.S. have been performing against the Dow Jones Industrial Average.
Over the past three months, banks have been making lower highs and lower lows. This could signal that banks are headed lower.
What’s the Next Step?
So what should you do if you’re holding financial stocks? It truly depends on your own situation. If you’re holding a profit right now, it might be time to play with the house’s money.
In other words, take your original investment capital back out of the trade and bank it. Then you can let the rest ride, and never take a loss. If you’re holding a significant profit, you might want to take a larger portion out of the trade to protect some of your gains.
How much is entirely up to you and what you’re comfortable with… But be prepared to leave the rest of your investment for a while.
We can’t be sure how much more bank stocks could fall. It could be 10%, it could be 5%. So moving forward, playing with profits, you could also use a stop-loss.
For those of you who are holding some losses with bank stocks, you have two choices: cut and run, or hold through the bottom.
Which you decide will depend on how big a loss you are holding. Of course, most advisors will tell you that holding a loss is just tying up your money.
As I said, we don’t know where the bottom is for financial stocks, but we do know they are still falling.
Here’s the thing. Buffett can afford to hold through a downturn because he’s already sitting on a profit. If you’re holding a loss, the smartest thing to do would be to have an exit strategy. If you’re sitting on a 20% loss, and you figure you might as well hold and hope for some little rise in the stock price, you’re setting yourself up for more losses.
Get out, and save your money. You can always buy more shares of that company once it puts in a clear bottom.
Article brought to you by Taipan Publishing Group. Additional valuable content can be syndicated via our News RSS feed. Republish without charge. Required: Author attribution, links back to original content or www.taipanpublishinggroup.com.
Sara Nunnally – About the Author:
Sara is Co-Editor of Smart Investing Daily. As Senior Research Director and global correspondent, Sara Nunnally’s diverse resume includes studies in art history, computer science and financial research. She has appeared on news media such as Forbes on Fox, Fox News Live, and CNBC’s Squawk Box, as well as numerous radio shows around the country.
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Article Tags:
stock warrant, goldman sachs, and warren buffett
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Growth stocks can mean different things to different people, but I personally define a growth stock as being shares in a company that continues to increase both it’s earnings and dividends each year (and has a long history of doing so). So with that in mind, I want to talk about when you should sell these stocks, because this is very important.
If you’re lucky enough to have found some good quality growth stocks and are sitting on some decent profits, then it can be tempting to bank your profits and reinvest the proceeds elsewhere. However, as Warren Buffett will tell you, this isn’t necessarily the best strategy.
The best strategy, provided that you’re prepared to hold on to your shares for the long term, is to resist the temptation to sell and hold on for further gains. Yes there may be short-term fluctuations along the way, but providing that the company in question continues to increase both it’s earnings and dividends each year, there is no need to sell because the share price will eventually rise to reflect this continued growth.
If you hold on to shares for as long as a company continues to grow and reinvest the dividends received each year, then you can be sure that you will be sitting on some substantial gains when you do finally decide to sell. This is something that Warren Buffett does to devastating effect. He simply looks for outstanding market-leading companies that continue to grow their profits each year, and holds on to these shares for years and years to benefit from both capital growth and dividends.
It requires a great deal of patience because in the short-term the share price can fall in line with the overall market, but in the long-term it rewards you with some fantastic profits. The difficulty is finding the right companies to invest in, but there are some obvious candidates amongst some of the large-cap stocks. For example here in the UK Tesco is a fantastic company because it has a long history of growing both it’s earnings and dividends. Indeed I believe Buffett himself owns shares in Tesco at the time of writing.
So to answer the original question of when should you sell your shares in growth stocks, you should hold on to your shares for as long as possible to benefit from both capital growth and dividend reinvestment. The only time you should consider selling is when there is a danger that the company may stop increasing it’s bottom line each year, maybe due to another major competitor gaining market share, for instance, because that will obviously mean that the share price is unlikely to continue rising in future years.
Click here to read a review of Stock Trading Nitty Gritty, the new training course that teaches you how to successfully trade individual stocks.
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Are you looking for the best way to build wealth? Why not seek the advice of the world’s best investor?
Warren Buffett says that the best way to maximise your wealth is to focus on your career and to invest in index funds. You may find that surprising advice from a great investor, yet it does make a lot of sense.
If you’re devoting your free time towards trying to out-smart the market at the expense of building your career skills, you may want to re-think your strategy.
Devoting your free time to building your career skills has a much better pay off than devoting it towards trying to out-smart the market. This is the philosophy of Warren Buffett and we think its pretty hard to disagree.
At the Berkshire Hathaway shareholders’ meeting in 2006 a shareholder asked a question along the lines of “how should I study investing in order to build wealth in my spare time?”
Buffett replied that, for most people, the bulk of their income is going to come from earning power in their chosen profession. Therefore, from the standpoint of building wealth, free time is better spent sharpening one’s professional skills rather than studying investing.
Source: Soul Shelter, “Billionaire Lessons in Prosperity Living”, April 2, 2008
The following comments are excerpts from the Fortune Magazine article, “What Warren Thinks”, published April 14, 2008:
What advice would you give to someone who is not a professional investor? Where should they put their money?
Buffett: Well, if they’re not going to be an active investor – and very few should try to do that – then they should just stay with index funds. Any low-cost index fund. And they should buy it over time. They’re not going to be able to pick the right price and the right time. What they want to do is avoid the wrong price and wrong stock. You just make sure you own a piece of American business, and you don’t buy all at one time.
What should we say to investors now?
Buffett: The answer is you don’t want investors to think that what they read today is important in terms of their investment strategy. Their investment strategy should factor in that (a) if you knew what was going to happen in the economy, you still wouldn’t necessarily know what was going to happen in the stock market. And (b) they can’t pick stocks that are better than average. Stocks are a good thing to own over time. There’s only two things you can do wrong: You can buy the wrong ones, and you can buy or sell them at the wrong time. And the truth is you never need to sell them, basically. But they could buy a cross section of American industry, and if a cross section of American industry doesn’t work, certainly trying to pick the little beauties here and there isn’t going to work either. Then they just have to worry about getting greedy. You know, I always say you should get greedy when others are fearful and fearful when others are greedy. But that’s too much to expect. Of course, you shouldn’t get greedy when others get greedy and fearful when others get fearful. At a minimum, try to stay away from that.
But you’re still bullish about the U.S. for the long term?
Buffett: The American economy is going to do fine. But it won’t do fine every year and every week and every month. I mean, if you don’t believe that, forget about buying stocks anyway. But it stands to reason. I mean, we get more productive every year, you know. It’s a positive-sum game, long term. And the only way an investor can get killed is by high fees or by trying to outsmart the market.
Wealth Foundations is an independently owned personal financial advisory firm that offers wealth management and strategic financial planning services. For more information, visit Wealth Advisers
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