Put a Lock on Your Buffett Bet

by Tyler Craig | April 30, 2013 11:54 am

Stock of the Week[1]With the recent surge above the century mark, shares of Warren Buffet’s flagship company Berkshire Hathaway (NYSE:BRK.A[2], BRK.B[3]) have officially ventured into uncharted territory. Indeed, with the S&P 500 vaulting above its 2007 peak, the number of stocks dwelling in the coveted land of all-time highs has swelled.

Remember: Reaching an all-time high is a watermark with all sorts of bullish implications. Here’s a short list:

  1. It means traders are willing to pay a price for the stock that no one before them was ever willing to pay.
  2. It means everyone who has ever purchased shares of the stock is sitting with a winning position. There are no “underwater longs” waiting for the stock to rise to their purchase price so they can exit at breakeven.
  3. It means previous shareholders who sold too early are watching the stock’s continued advance with mucho regret. They loom anxiously on the sidelines just waiting for a dip to jump back in.
  4. And finally, it means anyone currently short the stock is feeling more pain than ever before, making them all the more likely to cover their position, thereby adding further fuel to the buying bonanza.

Click to Enlarge
Interestingly, the price performance of Berkshire Hathaway has essentially matched the broader market. Since the infamous devil’s bottom in March 2009, the S&P 500 has climbed roughly 137%. Meanwhile, Berkshire Hathaway has followed in kind, rising 135% from just under $45 to $106.

As shown in the bottom panel of the accompanying chart, the correlation between the two has remained very high over the years and currently sits at +0.95. While the imitation of the broader market isn’t inherently a bad thing — particularly when the market is rising — the fact remains that most investors buy an individual stock with hopes that it will deliver better returns than buying a broad-based, diversified index fund.

The plot thickens when we add dividends to the mix. While owners of the S&P 500 Index have been rewarded with quarterly dividends, Berkshire has offered no such payout. The S&P 500 Total Return Index (which includes dividends) is actually up more than 150% since the March 2009 low.

At the risk of overcomplicating our simple comparison, suppose we also consider volatility. After all, if Berkshire delivered similar returns to the S&P 500 but was less volatile in the process, perhaps its risk-adjusted returns were on par or better.

While the S&P 500 has a beta of 1, Berkshire boasts a beta of 0.54, which means it’s theoretically half as volatile as the broader market. Traders certainly could make the case that Berkshire’s lower volatility compensates for its underperformance when compared to the total return of the S&P 500.

In light of Berkshire’s low volatility, its options really aren’t all that expensive. This acts as a detriment to option sellers, but an advantage to option buyers. While strategies like selling covered calls don’t appear all that attractive, buying protection via puts is a no-brainer for those looking to insure their recent gains.

With BRK.B trading at $106, you can purchase a Dec 105 put for $4.90. So basically, for less than 5% of the stock price, you can acquire the right to sell shares at $105 for eight months.

That is cheap insurance!

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.

  1. [Image]: https://investorplace.com/hot-topics/stock-of-the-week/
  2. BRK.A: http://studio-5.financialcontent.com/investplace/quote?Symbol=BRK.A
  3. BRK.B: http://studio-5.financialcontent.com/investplace/quote?Symbol=BRK.B

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