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.
It was about the $5 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.
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.
The stock warrants that Buffett bought have a "strike price" of $115. This means that he can buy shares of Goldman Sachs at $115… no matter what price the financial stock is actually trading at.
On Friday, Goldman Sachs closed above $151. If Buffett were to exercise his warrants, meaning "cashing in" his warrants for shares of the company, he would immediately have a $36 profit on every share of stock. That’s an instant gain of more than 31%.
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.
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.
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.
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.
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.
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.