Tuesday, November 18, 2008

The Warren Buffett Way: Chp 6 Part 5: Fixed-Income Marketable Securities

Salomon Inc.:

In 1987, prior to the stock market crash, Buffett had purchased $700 million worth of Salomon convertible preferred shares. The deal was requested by the CEO of Salomon, to help prevent a takeover of the company. Buffett knew the CEO of Salomon, John Gutfreund (from GEICO) and respected him as a person with integrity who put clients interests first. Buffett and Gutfreund were able to quickly craft the deal for Berkshire to buy the newly issued Salomon convertible preferred shares.

The reason Buffett purchased convertible preferred shares rather than common shares was that he wasn't confident what the the future cash flows of the business would be. However, he was still reasonably sure that Salomon would earn a good return on equity over time.

The Salomon convertible preferred shares paid a yield of 9%, were convertible to common shares at a price of $38 per share within 3 years, were redeemable by the company within 5 years starting in 1995 and were issued at a premium of 15% to the price of the common shares.

In the stock market crash of 1987, the common shares of Salomon sank in half. The common shares eventually recovered but in Aug 1991, the company announced that they had violated U.S. Treasury rules. After the announcement of this violation, the common shares fell to a price of $16 per share. Buffett stepped in as the interim chairman of Salomon to help the company through the crisis. After putting in place controls and a new management team, the company's share price rose to $47 per share by Dec 1993.

In 1994, Buffett purchased 5.5 million common shares of Salomon and Berkshire still held the preferred shares at that time. It is surmised that Buffett made the common share purchase because he was much more confident about the company's prospects after being the interim chairman and was able to put in cost controls and a new management team.

Buffett acknowledges that the value of the preferred convertible shares that Berkshire purchased came mostly from the fixed income aspect of those securities as opposed to the convertibility aspect.

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