Today as soon as I woke up and logged on to yahoo finance, as I routinely do, I was surprised to see Bank of America’s (BofA’s) gain of 25%. That converts to nearly $19 billion in absolute numbers (of course, it shed some of its gains later). Then I saw the news and came to know about Warren Buffett’s investment of $5B in BofA. Then I started reading about the whole thing. First of all I wondered how powerful that $5 B is. In an hour or so (market was opened just half an hour before or so), those $5 B earned $19 B (at least on paper). Then I started reading the news on this topic. Almost all of the articles mentioned a rare instrument in investing world – “Credibility”. Yes, you read it right. More than the $5 billion, Buffett lent his credibility to BofA. Just in case you are NOT familiar with this word in investment world, as I am, then here is the Oxford dictionary’s definition of “Credibility” – “The quality of being trusted and believed in”. That means Buffett’s quality of being trusted/believed in is lent to BofA. But who is trusting here, really? That’s right. You, myself and many investors like us. By the way, if you are tempted to ask me why I took the definition from Oxford dictionary and why not from others, then my answer is credibility :). Yes, I believe in the quality of Oxford dictionary. OK, let’s leave the linguistic part of the discussion aside and start on the main part – Financial part of the news.

I know a few people who mimic the prominent investors’ portfolios. If you are the one of those who wants to follow “THE legendary investor”, then take a moment and read the below analysis. after you read it and give it a thought, then you can make the decision by weighing in all the information available to you.

To analyze how this deal works out for OTHER investors, let’s look at Buffett’s similar past investments. On SEPTEMBER 23, 2008, Buffett invested $5 B in Goldman Sachs (GS). On the next day after the news was made public, GS gained more than 4% and closed at $125 compared $120 a day before. The next three days were also good though the gains were NOT as good as the first day’s. Then market dynamics started working and they brought the stock down to $120. Then the trend was more like seesaw. As per the terms of the deal, Buffett got 10% annual dividend and also the warrants at a strike price of $115. These warrants were good for 5 years. Warrants are like options. Once you acquire them at a some strike price, either you can buy the underlying stock at the strike price within the validity period or you don’t have to if you don’t want to. For example, within these 5 years if the GS stock price goes above $115, then you convert those warrants into stocks by paying just $115 each, even if the price is $200. If the stock goes down, then you don’t have to buy and you won’t lose any money. The deal gave him a 10% dividend and these warrants at a discounted price on the closing price of Sept 23rd 2008. The closing price was $120 and he got them for $115. A regular investor would have got only 1.3% dividend on his/her investment where as Buffett got a whopping 10%. In the next 5 years from Sept 2008, if the stock price goes down, it wouldn’t cause him any loses. A normal investor would lose the money as much as the stock goes down. By the way, normal investors own something called common stocks. In case of liquidation, a company has to clear all its debts first and then the preferred stock would get the preference and at the last the common stock. The stocks that Buffett owned were Preferred Stocks which means his risk is less comparative to a common investor’s risk.

Note: All the calculations are done through simple calculations. Compounding is not used for simplicity purpose.

If we do simple math with the stock prices then we can see how much money Buffett would have made from GS investment vs how much a common investor would have made. Let’s scale Buffett’s investment down to a common man’s range. Buffett invested $5 B and let’s take $1 per every $1 M he invested. That comes to $5000. Let’s say a common investor invested $5000 in GS on the same day as Buffett did. The closing price of GS on 23rd Sept 2008 was $125.05 and today’s closing price is $109.84. Dividend for normal investors is $1.3%. The inflation rate of US in 2009 was -0.34% and in 2010 was 1.64%. That means the net inflation is 1.3%. A normal investor who had invested $5000 on Sept 23rd 2008 in GS would have lost 12% in stock price ( (125.05-109.84)*100/125.05 ). The net gain after factoring in inflation and dividend is (dividend 1.3*2)-( stock price change 12)-(inflation 1.3) = -13.3%. That means he would have been left with $4335. Let’s see how much Buffett would have made with the same terms he got. The net after inflation adjustment is (dividend 10*2) – (inflation 1.3) – (stock price change 115-109.84) = 6.7%. Had he invested $5000 then he would have been left with $5675. That means he can make 27% more than what an ordinary investor would have made.

If the normal investor hadn’t followed Buffett, then would he/she have left with better investment opportunities? Let’s see some examples. The change in S&P index between Sept 23rd 2008 and today is -2.4%. The net after inflation adjustment would be -3.7%. That means normal investor would have $4815 for his $5000. That’s nearly 10.5% more than the amount he would have gotten with GS investment. Being the index of 500 stocks, S&P is much less risky compared to GS.

Let’s see at AT &T which pays 5.9% dividend to the investors. The change in stock price is +1% (29.06 – 28.75). The net gains after dividend for 2 yrs and deducting inflation for two years would have been +11.5%. That means your $5000 would have been $5575. Though we cannot generalize, telecom stocks are less risky compared to financial stocks.

I am sure you will end up with the same conclusion if you analyze Buffett’s investment in GE that took place around the same time.

Today with BofA’s deal too, Buffett made a similar agreement. He would be paid 6% dividend where as normal investors would get only 0.6%. That’s ten-fold. He got warrants at strike price of $7.14 which are valid for 10 years. In these 10 years, he can buy 700 million stocks at $7.14. No matter how high the stock goes, he would still get them at $7.14 each. On the flip side, if the stock goes down, he will get his money paid back by BofA with the dividend and he doesn’t have to use those warrants. As a regular investor you won’t have this flexibility unless you buy Options. Of course, you won’t get 10 yr valid Options anyway.On top of these he also got 50,000 preferred stocks.

I like to bring an economic theory called “zero-sum game” to your attention. As per Wikipedia it means, a zero-sum game is a mathematical representation of a situation in which a participant’s gain or loss is exactly balanced by the losses or gains of the other participant(s). To rephrase this in layman’s terms, someone’s gain must be equivalent to other’s losses. Sum of cumulative losses and gains would be equal to zero. Buffett is sure on the gaining side. To compensate those gains somebody has to lose equal amounts. If you follow him, you decide on which side you would be – the gaining side or the losing side.

What I mean to highlight here is, it MAY NOT always be wise to blindly follow a successful investor. It may not always lead you to profits. Buffett is a legendary investor and so as his deal with BofA. At the end of the day, company’s performance and market dynamics weigh in and they are the REAL factors that make the stock move up or down. For a company with $77 B market cap, $71 B revenue and $94 B operating cash flow, $5 B would not make much difference. What BofA is trying to buy from Buffett is investor’s (all of our) trust. Buffett is selling/lending it to BofA. It’s up to the investors to look at the fundamentals and make the right decision.