Warren Buffett is considered to be one of the most successful investors of all time.
He started investing in stocks at the age of 10 and was a millionaire by his early 30s when he started buying Berkshire Hathaway shares at $7.60 a share. Today, Berkshire trades for about $400,000, and Buffett has a net worth of $97 billion.
Buffett is known for his approach of buying large chunks of blue-chip companies with undervalued prospects and strong management. Then he holds those shares for years, if not decades. The secret to his success, he says, is to follow two rules:
“Rule #1: Never lose money. Rule #2: Never forget rule #1.”
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But there are three lesser-known tactics Buffett has used to build his fortune that savvy investors might want to borrow — even if they sometimes run counter to his better-known investment strategies.
1. Selling put options
You’d think someone like Buffett, who seems devoted to blue-chip stocks, would avoid complicated derivatives, but you’d be wrong.
Throughout his investment career, Buffett has utilized the advanced options trading technique of selling naked put options as a hedging strategy. In fact, in Berkshire Hathaway’s 2007 annual report, the company acknowledged that it had 94 derivative contracts that generated $7.7 billion in premiums during the year.
This strategy involves selling an option where you promise to buy a stock at a specific strike price below its current value sometime in the future. This immediately gives you money from the sale of the option. If the share price does not fall, you keep the money.
If the price falls below the strike price, you buy the stock for less than you would have paid at the time you sold the option, with cash from the option sale further reducing your cost basis. This is a good strategy on a stock that you wouldn’t mind owning in the first place. In 1993, Buffett used put options to pocket nearly $7.5 million in income while he waited for the price of Coca-Cola stock to drop.
The option is considered “naked” because you have not secured another option to buy the stock, such as shorting shares of the same stock to offset your purchase costs.
But keep in mind that given the risk involved, this is not something a novice investor should attempt on their own.
2. Investment in small-cap stocks
When you’re throwing around the kind of cash that’s measured in the billions, getting stock in promising new companies isn’t going to work. Shares of small-cap growth stocks in companies typically worth $300 million to $2 billion would simply move too much if the Oracle of Omaha made a purchase big enough to make it worthwhile.
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“I have to look for elephants,” Buffett once said when discussing his investment options. “It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I have to live in.”
Of course, it wasn’t always like that. Buffett started his career investing primarily in small companies. He invested more than half of his net worth in GEICO—when it was still relatively small—in 1951 at the age of 20.
One of the reasons the so-called “mosquitoes” are attractive is that stocks show the greatest growth in the early days of a company’s operations. But just because these little outfits aren’t allowed for Buffett today, doesn’t mean you can’t go for them.
3. Cutting losses when necessary
Buffett’s “buy and hold” approach does not extend to never admitting that even he is sometimes wrong. Once losses occur in a well-run business, it is a sign that the finances of that business may have changed in a way that will create losses for a long time to come.
As for Buffett, his big misstep recently was investing in airlines. Berkshire Hathaway once owned a stake in all four major US airlines: Delta, American Airlines, Southwest and United. While he first added these companies to his list in 2016, by the end of 2020 he had dropped them all – at a relatively large loss.
Buffett took responsibility for the failed strategy, but was clear that he saw no future in airlines, even going so far as to call the industry a “bottomless pit.”
“We’re not going to fund a company that — where we think it’s going to chew up money in the future,” he said at the time.
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This article provides information only and should not be construed as advice. It is provided without warranty of any kind.