Buffett buy underscores the obvious: Goldman Sachs is vastly undervalued

Warren Buffet just invested 5 BILLION dollars (to quote Dr. Evil) in Goldman, Sachs, and has the option to buy another 5 billion. This is very significant, and I expect the market to react very positively to this news.

Goldman shows how market panics work: they throw out the baby with the bathwater. While I'm still of the opinion that there is much, much more bathwater to be drained, Goldman was caught in the fever to dump all investment bank stocks. This was ridiculous, since Goldman stood alone among the investment banks in refraining from participating in the subprime market. Its balance sheet was the strongest, and it was still making money up to the present. Profits fell, of course, but at a time when others are writing off billions, a black bottom line should have kept its stock at healthy levels. When your competitors are all dying, hardy survival should point toward future dominance in your sector. In this case, the market went insane and Goldman was on the verge of destruction itself.

Enter Warren Buffett. Buffett's vote of confidence is particularly heady when you look at the deals he passed on. Remember Long Term Capital Management? Buffett was asked to buy its assets for 10% of their value; he wanted to pay just 5%, so it wasn't a good enough deal. Buffett only commits his money when there is a very high chance of profit. He would have made money on LTCM even at 10%, and clearly the firm's positions appeared to be eventual winners when the market settled down, but on short notice saw no reason to take on any risk. Buffett has passed on other potential deals as well, including Bear Stearns last year.

But Goldman passes the Buffett test. The market should like this news, but I think people will read too much into it. Goldman is a special case; alone among almost all the banks of any type, they showed better judgement when it came to subprime loans.

If the market takes this as a signal that the market is out of the woods, sometime after tomorrow's jump they will be sorely disappointed. Because for every Goldman out there, there are 100 firms who lended/insured/traded irresponsibly and could still fail, despite the pending government intervention. Goldman did things (relatively) right, and still got burned. Buffett's investment is a reality check on the upside—strong firms should not fail. But the market may act like Buffett bought S&P 500 futures. He didn't; he did what he always does—look at individual stocks, and buy the ones he thinks are unfairly valued.

The buy raises another significant question. Goldman (and Morgan Stanley) got permission to change into standard commercial banks. This was necessary to insure proper cash flow, but comes with a regulatory price that will diminish profits. With Buffett's investment (and with Buffett as a potential instant source of emergency funds?) does Goldman need to change its status? Can they remain an investment bank with Buffett as their sponsoring angel, and keep profits high as before? Buffett might have this in mind. As the only major investment bank, Goldman's profits could be higher than ever when the current market turmoil ends.

It's just as likely, though, that Goldman's status change is what made Buffett pull the trigger. Goldman won't be engaging in as much high-leverage trading as a commercial bank, which would suit Buffett just fine. The Goldman Sachs name alone, like Coca-Cola (one of Buffett's favorite all-time holdings), will sell its product.