Should You Stay Invested in Finanical Stocks?

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 …

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 $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.

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 $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%.

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But Buffett says he’s holding his warrants.
He’s betting that Goldman Sach’s share price will continue to increase.
(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.

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