Buffett's $5B investment in Goldman Sachs could pay off

NEW YORK -- Warren Buffett's $5 billion investment in Goldman Sachs gs, Wall Street's most prestigious bank, was vintage Buffett.

The savvy billionaire executed his legendary buy-on-the-cheap strategy to a T.

Buffett bought Goldman stock when fear was high and the price was low — almost 55% below its 52-week high of $250.70. He grabbed a big stake in a firm considered best in its class. He got a 10% dividend to reduce risk. And he didn't have to buy any of the toxic mortgage-related assets, which the federal government is proposing to do in an effort to thaw out frozen credit markets and get financial markets working smoothly again.

While the deal is far from risk-free, the turbulence and fragility of financial markets suggest Buffett got a pretty good deal and stands a good chance of making money.

"It's a very savvy strike by Buffett into a very panic-stricken marketplace," says Jeff Matthews, a hedge fund manager, blogger and author of an upcoming book, Pilgrimage to Warren Buffett's Omaha. "He's not buying any bad debt. He is buying a very secure ownership in Goldman Sachs."

In a statement, Buffett hailed Goldman's "global franchise and deep management team." Buffett's Berkshire Hathaway brka will buy $5 billion of perpetual preferred stock, which pays out a fat 10% dividend. Berkshire also gets the right to buy in the next five years another $5 billion in Goldman common stock at $115 a share. Goldman shares rose $7.95 Wednesday to $133, so Buffett is already up $18 a share.

"Buffett is basically betting that the financial system does not collapse," says Michael Holland, a New York-based money manager.

Raising capital was the "right thing" for Goldman to do given an anticipated wave of bank-capital raising, Merrill Lynch analyst Guy Moszkowski wrote in a report. "The high cost is a sign of tough times," he noted. Still, "We see an investment by Buffett as … the ultimate validation of Goldman's pre-eminence and its long-term prospects."

The deal comes amid one of the worst financial crises on Wall Street since the Great Depression. It followed a full-day of contentious debate on Capitol Hill over the fate of the government's $700 billion Wall Street bailout plan. It follows the bankruptcy protection filing of Lehman Bros., the bailout of insurer AIG and the government takeover of the nation's two mortgage giants.

Given the timing of Buffett's move and his stature on Wall Street, it is the most direct show of confidence in the financial system, which just last week seemed to be on the brink of collapse.

"The mere fact that the world's greatest investor is willing to back a company like Goldman at this time signals confidence," says Vahan Janjigian, chief investment strategist at Forbes and author of Even Buffett Isn't Perfect.

This is Buffett's second major investment in a Wall Street bank. In 1987, he invested $700 million in Salomon Bros. and ended up having to rescue the firm from a trading scandal by taking over as interim chairman in August 1991. He stepped down in 1992 and five years later sold his stake to what is now Citigroup for a profit.

The fact Buffett signed the check before Congress passes its bailout plan is risky, because financial stocks could take another hit if investors "are not happy with what Congress comes up with," says Edward Yardeni of Yardeni Research.

To some degree, Buffett's stake in Goldman is surprising; he has been critical of investment banks for taking on too much risk and charging high fees. Goldman also invests in derivatives, which Buffett has called "financial weapons of mass destruction," Mark Lane, analyst at William Blair, noted in a research report.