Can Buffett Rescue the Market?

Warren Buffett warned several years ago about a financial crisis like the one currently engulfing Wall Street. But now that it's here, the investing wizard has decided he might as well profit from it.

The legendary investor's Berkshire Hathaway (BRKA) is making a $3 billion investment in General Electric (GE). The deal was announced Oct. 1, one week after Buffett bet $5 billion on investment bank Goldman Sachs (GS).

For a U.S. stock market that has lost more than a fifth of its value this year, the deals represent a rare vote of confidence. Buffett warned of the dangers of complex financial products and too much debt—two of the main causes for the market frenzy. But despite those long-standing misgivings, Buffett is now confident enough to invest in two companies near the eye of the financial storm. "When you have the world's most successful investor stepping up and taking meaningful positions [in companies like GE and Goldman Sachs], it signals confidence not only in those companies, but the system itself," says Matt Kaufler, portfolio manager of the Touchstone Value Opportunities Fund.

Buffett's role in the crisis is similar to the roles that wealthy bankers and industrialists have played in previous crises, says Robert Bruner, the dean of the University of Virginia Darden Graduate School of Business Administration and the co-author of a book on the Panic of 1907. In that crisis, financier J.P. Morgan, with help from other bankers and investors like John D. Rockefeller, put up money to bail out banks and ease the economic panic. In a time of crisis, key figures can help "create a tipping point in favor of recovery," Bruner says.
Buffett's No Morgan

Yet no one thinks Buffett can stem the crisis the same way Morgan did 100 years ago.

In fact, in the short term, Buffett's Goldman and GE deals might merely emphasize the current difficulties. Who could have predicted just a year ago that Goldman Sachs or General Electric, two premier U.S. enterprises, would need Buffett's cash on such a large scale?

Along with Buffett's $3 billion investment in preferred shares, GE will offer common shares publicly to raise $12 billion. That cash is needed to prop up GE's financial units. Buffett's shares will get an attractive dividend of 10%. Buffett will also get warrants to buy another $3 billion of common stock at $22.25 per share; a year ago, GE's stock was trading above $42. (More on the GE deal here.)
Not Charitable Investments

Buffett's Goldman Sachs investment offered him similarly attractive terms. Buffett told CNBC on Oct. 1: "These markets are offering us opportunities which weren't available six months or a year ago. So we're putting money to work."

These are "iconic American companies," says Richard Sylla, of New York University's Stern School of Business. "[Buffett is] getting a chance to buy them cheap."

Buffett is able to exploit the current environment in ways most investors simply can't. "He's not making these investments out of charity," Bruner says.
Rich With Cash

While others are overwhelmed by large losses or stuck with high levels of debt, Buffett has billions of dollars in cash to deploy. "When crises like this happen, it's he who has the cash who can take advantage of it," says Robert Miles, a Buffett expert and author of the book The Warren Buffett CEO. Miles says historically Buffett has done his best when the broader market has done its worst.

This is not the first market meltdown that Buffett has successfully foreseen. Buffett was skeptical of Internet and other technology stocks in the late 1990s and early 2000s. Berkshire Hathaway shares suffered during the tech boom as a result, but Buffett was proven right when the tech bubble burst from 2000 to 2002.

In recent weeks, as the federal government has proposed a $700 billion bailout plan, analysts have frequently quoted Buffett's warning in 2002 that highly complex financial products like derivatives are "financial weapons of mass destruction."
Creating a "Halo Effect"

Buffett's record is what gives him such credibility at a time when nearly all other major financial players have stumbled. "His gravitas carries a halo effect" for the companies he invests in, Bruner says. "It's a vote of confidence" in General Electric and Goldman Sachs.

Standard & Poor's Rating Services on Oct. 1 said the Berkshire Hathaway investment was a "positive development" for the ratings on General Electric's debt.

Buffett's reputation—and the fact that he has billions to invest at a time—are exactly why he's able to get such attractive terms for his investments, analysts say.
Not Available to the Average Investor

Yet it's hard to predict how much Buffett's buying spree might prop up investor confidence in the broader market, and whether, like Morgan's dealmaking a century ago, it can help ease the current financial crisis.

After all, the bargains available to Buffett aren't necessarily available to the average investor, who can't get a 10% dividend on their GE shares. Also, analysts say, few other investors have so much cash to invest. "For some people, I think it's reassuring to see him allocating capital," Kaufler says. But, "some are so shell-shocked by the last 30 days, they're going to stay in their bunker."

Who knows? Buffett may have a few more surprising —and highly profitable —moves in mind as the financial crisis drags on.