Takeaways From Buffett’s Preferred Stock Deal: An Investing Strategy

Warren Buffett is a hypocrite.

At least, that’s the talking point about the famous billionaire since he announced his involvement in Burger King Worldwide’s (NYSE:BKW) proposed takeover of Tim Hortons (NYSE:THI), the Canadian coffee and doughnut chain with a cult-like following.

You see, rumors are circling that the deal will result in another tax inversion, with Burger King fleeing to Canada in order to pay a lower corporate tax rate.

Yet just a few months ago, Buffett stated, “We do not feel that we are unduly burdened by federal income taxes. But it does get a little annoying to us when we see other people paying far lower tax rates while engaging in the same sort of business that we engage in.”

Of course, it’s possible that Buffett was just being critical of high U.S. taxes and not tax-inversion deals themselves… but don’t tell that to the mainstream media.

Either way, Buffett’s Berkshire Hathaway (NYSE:BRKb) is not going to play a role in managing the combined company and is simply providing $3 billion in financing in return for preferred stock.

It’s actually a fantastic deal for Berkshire shareholders, so instead of roasting Buffett, let’s be more constructive.

The way I see it, there are three major takeaways from this artery-clogging deal…

h2 1. High-Yielding Preferreds Are Attractive/h2

Preferreds are often shunned because people fear poor performance in a rising interest rate environment (which hasn’t happened). But many preferreds offer a great risk-reward profile.

Meanwhile, Buffett has an affinity for preferred stock, which is senior to common stock, but junior to debt. Basically, it’s safer than straight equity and has bond-like characteristics.

Over the past few years, Buffett has acquired preferred equity stakes in companies such as Goldman Sachs (NYSE:GS), Bank of America (NYSE:BAC)), and General Electric (NYSE:GE).

In the case of Burger King, he’s getting a juicy 9% preferred dividend yield, which is even better than it sounds since this is not a distressed, capital infusion-type deal.

But besides providing relative safety, why would Buffett favor preferred securities right now?

Well, for one reason, his favorite market valuation indicator is getting overheated…

h2 2. Common Stocks Are Expensive, As a Whole/h2

The chart below shows the ratio of total U.S. stock market capitalization to gross national product (GNP).

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Now, some perma-bulls will take issue with this – or any other – type of market valuation analysis. Don’t listen to them.

In a 2001 Fortune article, Buffett described the ratio as “the best single measure of where valuations stand.”

And right now, the stock market/GNP indicator is telling us that the expected return for the stock market is low on an intermediate time frame.

h2 3. Expensive Stock Markets and Expensive Buyouts Go Hand in Hand/h2

Typically, when you see buyouts with sky-high multiples, the market has gotten expensive.

The $12-billion Tim Hortons deal is no exception. The offer represents a premium of 30% over Tim Horton’s stock price on August 22, 2014, and richly values the company at 16x EBITDA.

It’s clear that accommodative monetary policy is helping to fuel a buyout boom, with the median EBITDA multiple for buyouts having eclipsed 2008 levels.

Ultimately, the Burger King-Tim Hortons deal serves as a reminder that we can’t truly invest like Buffett. We’re simply not going to get offered these types of sweetheart deals.

But we can follow a Buffett-esque approach…

After all, combining the capital appreciation of cheap dividend growers with the income from high-yielding preferred stocks is a terrific portfolio strategy.

Safe (and high-yield) investing,

BY Alan Gula, CFA

Original post

Written By: Wall Street Daily