Many people ask me why we don’t just buy stocks when we find an undervalued business, as opposed to some combination of buying stock and selling cash-secured puts, among other strategies. If a stock is more than 50% undervalued, we will usually primarily buy the stock outright. If the discount isn’t as great, selling puts is a great way to manufacture a cheaper entry-price, ultimately making the trade less risky. Most of the options we sell either expire worthless or are exited profitably prior to expiration. Because we are in control of the terms and prices at which we sell the options, we can pre-arrange that we are happy with the targeted returns assuming they expire worthless prior to setting the trade.
We only engage in stocks that we’d be willing to own anyways, so when the market sells off taking our stocks down with it, resulting in us getting exercised, we are perfectly happy owning the stocks for the long-term but this time at an even better price than we could have gotten originally. Warren Buffett uses a similar strategy by selling long-term put options on various stock indices. Studying Buffett, I believe that it is very likely he would also do it more often with individual companies but he manages so much money that often the liquidity isn’t there to do so. He certainly used this strategy when he was acquiring stock in Burlington Northern Santa Fe, which turned into a stellar investment for him. The article below talks a bit about this but also talks about a way that he is structuring a high probability insurance bet on the NCAA basketball tournament where Berkshire Hathaway is insuring a $1 billion prize for a perfect bracket. Using options on value stocks in the way that we do takes a lot of work and monitoring, but I believe it gives us a huge advantage. The key is good stock selection and having the patience to let time elapse, without panicking during short-term market sell-offs.
It seems like a very high probability that at some point in the next year or two we will have a 10-20% sell-off in the indices, which would likely test many investors mettle but I can assure you that our investment strategies are designed to combat that and ultimately take advantage of those opportunities. Complacency is very dangerous, which is why if you are just long stocks outright through a mutual fund or something like that, I’d urge caution and consider shifting your assets, hopefully to us as I believe we can do a great job for you. Thank you very much and I hope that you had a wonderful Martin Luther King holiday!