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To: Dale Baker who wrote (30496)	7/11/2002 10:33:59 AM
From: Dale Baker	Read Replies (1) \| Respond to of 118717

Jubak: Warren Buffett's latest lesson This week, Warren Buffett plunged in where other investors have feared to tread. He plunked down $100 million on a corner of the telecom sector. Is Buffett betting on a quick telecom rebound? Not likely. By Jim Jubak 4:39 PM EST July 10, 2002 It’s the “how” of this deal that investors should watch. Sure, the headlines are impressive: Warren Buffett, Longleaf Partners and Legg Mason (LM, news, msgs) make a $500 million bet that Level 3 Communications (LVLT, news, msgs) will be one of the survivors of the telecom shakeout. But look at what these savvy long-term value investors bought. Not shares of the straight common stock that were selling at just $2.89 each the day before the deal was announced. And not the company’s bonds, which were trading at about 35 cents on the dollar with a junk rating from Standard & Poor’s. Driving the convertibles off the lot Instead, the Berkshire Hathaway (BRK.A, news, msgs) CEO and friends bought $500 million in convertible bonds. What’s a convertible bond? Convertibles are complex securities that pay interest like a bond for a set period of time -- in this case 9% for 10 years. But they also give their owner the option of converting the bond to shares of common stock at a set price. In the case of the latest Level 3 option, that price was $3.41 a share. Converting the bonds into equity would give the three investors ownership of 27% of level 3. A good deal for Level 3... The benefits to Level 3 are pretty clear. Paying 9% interest to raise new money is a bargain. Like other telecom companies, such as Qwest Communications (Q, news, msgs), Level 3 has to pay junk-bond rates because of the risk that the company won’t survive the shakeout in the sector. Before the post-Buffett rally in Level 3’s bonds, the company’s debt was yielding about 35%. And the new investors also paid an above-market premium for the potential stake of 27% of the company. At July 5 prices, for $500 million, the three investors could have bought 42% of the company’s outstanding stock. ...and for the investing troika The conversion feature in the deal gives Buffett and friends a 10-year option on the common stock. When most options expire in weeks or months, that’s an extraordinarily long option and hence, extraordinarily valuable. Think of it this way: Buffett, Longleaf’s Mason Hawkins and Legg Mason’s Bill Miller don’t have to get the timing of any eventual turnaround at Level 3 even vaguely right. As long as “eventually” arrives sometime during the next 10 years, they’ll make out just fine. And thanks to the 9% yield on their investment, Buffett et al get paid to wait for that option to pan out. Given what we know about Warren Buffett’s thinking about future returns in the stock market, 9% looks mighty attractive just on its own. At the Berkshire Hataway annual meeting, Buffett told investors to expect 7% to 8% annually from the stock market over the next decade. At 9%, he’s ahead of the game. What about us little guys? Now nobody is about to offer most of us this kind of package. But individual investors can build one of their own. For example, buy common shares of Level 3 to create that long-term option on the company’s future and just enough Level 3 debt -- currently yielding 28% -- to give you a yield on the value of the whole investment of 9% or so. Your option won’t be as attractively priced as the one Buffett got, but, hey, consider the difference the cost of riding on the master’s coattails. Or, if that premium is too high, strike out on your own and put together your own combination of junk bond and common stock in telecommunications or another sector. There’s certainly plenty to choose from. Just don’t forget Buffett’s core principle: buy good businesses. No amount of packaging will save your capital if you pick a business that’s headed for failure.