2023-08-29 17:45:16 ET
Summary
- Berkshire Hathaway B shares have failed to outperform peers over the past decade, partly due to the lack of dividends.
- Using derivatives to create synthetic dividends can boost returns and create compounding opportunities for Berkshire Hathaway shareholders.
- The company is undervalued and offers significant upside potential, making it a good investment option for long-term investors.
- The two strategies mentioned are only viable for investors with existing familiarity with derivatives and the Greeks.
Berkshire Hathaway ( BRK.B ) (BRK.A) is a firm synonymous with quality leadership and an investment many Americans count on as something they can hold for the long term. I firmly believe the Americans making this assumption are correct in trusting Mr. Buffett and Mr. Munger as wise stewards of their capital. Berkshire B shares have had a fantastic run of performance. Still, the B shares have failed to outperform peers of the last decade.
Of course, this is not to say that Berkshire Hathaway is a lousy place to store your capital. At the same time, some peers that outperformed or matched Berkshire's performance did so because of their entrenched competitive positions in the consumer credit market. However, you can also see that dividends made a difference as well. For example, Compass Diversified ( CODI ) had only about 10% of the price return of Berkshire, but when you factor in dividends, it returned 151.5% to Berkshire's 219.68% over the past decade.
So, this shows that even though Berkshire Hathaway has a lot to like as a stock, one of its major weaknesses is that it doesn't pay a dividend. Of course, the compounding that dividends allow for has been central to Mr. Munger and Mr. Buffett's success over their storied careers. However, they have decided to reallocate the capital they receive in dividends rather than distribute it to shareholders.
You can see that Berkshire is having a rebound in its net income. Remember that while Visa and Mastercards can be considered tangential peers in some ways, comparing their margins on an apples-to-apples basis with Berkshire doesn't make the most sense. They have an oligopoly and consistently have some of the steadiest and highest margins in the market. This is probably why they are Berkshire's 16th and 17th largest holding.
I think it's good advice to buy Berkshire and not think about it to a certain extent. However, for the more enterprising investor, I think there is a lot of opportunity to boost your personal ROE and create an opportunity for compounding with the stock that wouldn't otherwise exist.
You could quickly reach an average yield of around what would typically require a significant payout from the company that is instead re-investing under the hand of the best in the business. If you consistently implement the strategy within a reasonable framework of rules that you can use or disregard at your discretion, depending on your comfort with assignment and repurchasing.
This is an active strategy requiring the use of derivatives, so it is not for everyone. It's hard to argue against Buffett using the capital he wants to. However, there's also no benefit to creating a dividend that increases your return and share count. However, if you don't understand the options market and know your Greeks well, this strategy is not for you.
I would highly recommend reinvesting the proceeds of this strategy to maximize the long-term benefits. I don't advocate trading Berkshire Hathaway; I advocate owning it but supplementing returns with active covered calls and cash-covered puts to augment returns.
OptionStrategist.com
However, I think Berkshire B shares make the perfect candidate to create synthetic dividends to boost the margin of safety. Don't think of this strategy as trading in and out of the stock but rather as creating a better long-term ownership profile. First, though, let's see how advantageous the margin of safety is already without this strategy and why Berkshire is a buy right now despite being close to highs.
Valuation and Why Berkshire is a BUY
Berkshire is a highly sought-after quality stock that appears on the upswing. Exposure to the shares provides an inherent diversification that most stocks cannot offer. This enlightening article by a fellow Seeking Alpha contributor also makes a compelling case for why you can get better exposure to some blue chip stocks through Berkshire. The company recently posted a bumper earnings beat as well.
As you can see, the earnings will slow down next year, but there's still some gas in the tank. However, the last earnings beat suggests the firm could continue beating expectations. Even in the face of Mr. Buffett's highly publicized bet on Treasuries, which some have taken as a bearish move. I don't concur it is necessarily that.
The EPS revision trend is painting a positive picture as well. But the real reason to own Berkshire is because it is intrinsically undervalued despite its recent strength. As you can see below in the valuation summary, the company is undervalued pretty much across the board. So, you already have a significant margin of safety on this name if you want to buy it on these merits alone without getting fancy.
As you can see, this high-quality conglomerate has a significant upside that should appeal to long-term investors. Upside that can be significantly augmented with an active synthetic dividend strategy. The diversity and economic significance of Berkshire's core holdings mean that getting this kind of diversified exposure on the cheap when the market valuation is elevated is an excellent way to achieve a balance of potential for alpha and safety.
So, I think Berkshire Hathaway B shares are a buy either way. However, I think for those comfortable with using derivatives and other strategies like having an order ready to execute if you get assigned or potentially using cash-covered puts to juice returns even more, you can significantly add to your margin of safety and add to your share count.
Use Covered Calls to Create a "Synthetic Reinvested Dividend"
There are several ways to use derivatives to create an income stream on a stock that doesn't usually pay dividends. Mr. Buffett has called derivatives "financial weapons of mass destruction" for a reason. Still, they can also be used within reasonable risk parameters and with stock ownership to boost returns with minimal additional risk. Indeed, with some planning and a consistent process, you can eliminate the slight risk.
The covered call element of the strategy is pretty essential, but with a little twist that adds some yield and furthers the goal of compounding.
1. So sell covered calls with your desired methodology and strategy for selection, whether it be ATM or 10-15% OTM or whatever.
2. Save the premiums as cash until it is enough to write a cash-covered put.
3. You can then use the cash to basically set a limit order, which will allow you to purchase the stock at a discount, and if the limit isn't hit, you'll continue collecting premiums.
4. Repeat this process to add to your share count, as if there were a re-invested dividend, and achieve compounding over time.
Using covered calls to create income is pretty straightforward and is one of the most basic and lowest-risk derivatives strategies. Seeking Alpha has excellent educational resources on many strategies and terms, including covered calls . Before I delve much more into the strategy, I do want to clarify a few things about it:
- The vital thing in this strategy with Berkshire is a measured and consistent strategy over time in which the proceeds are invested back in Berkshire Class B shares.
- Thus, this is not a strategy for outsized returns in a short period but rather for achieving compounding in a high-quality stock that lacks a dividend. This can only be achieved over many years, not quarters.
- There is some familiarity with trading and with the options required. If you do not have the prerequisite knowledge, you should not try this trade.
- Only investors familiar with option assignment, mitigating its risk, and writing options should consider this strategy.
- If you have owned a stock for years and are sitting on capital gains, you may not want to use covered calls, as selling could trigger unwanted tax liabilities.
I'm not delving into the basics of covered calls, but I will note some basic road rules for your call selection. First, use the Delta to ensure you're picking options to sell with a good chance of expiring out of the money and thus avoiding assignment. If you're getting assigned all the time, it can diminish the strategy's effectiveness. Secondly, make sure to select contracts with good liquidity. One proxy for liquidity can be the ask/bid spread. Generally, the tighter, the more liquid. Thirdly and most importantly, always set strike prices that give you capital gains you are happy with in case you get assigned.
A Second Strategy: Introducing New Capital In a Wheel Trade to Generate Income and New Shares
Maybe Berkshire is a core multi-generational holding for you or your family office, and the last thing you want to do is deal with the hassle of assignment on a legacy position that might anchor or be a significant holding in your portfolio. Many folks might think a synthetic dividend is out of the question. Still, you might want to introduce new capital intending to provide an income stream on your Berkshire stock. You might be able to achieve both the goal of avoiding tax consequences and creating a synthetic dividend.
With the Options Wheel Strategy, the objective is not to own a stock for long-term capital appreciation but to generate income from premiums and to facilitate buying low and selling high. You can write cash-covered puts to build a premium; once they are assigned, you generate income from the stock you had an obligation to buy with covered calls.
For this strategy to be effectively used against a legacy Berkshire position the owner doesn't want to sell at this time, you could create a new position of cash-secured puts. Obviously, the larger the potential position this assignment would create (and thus the higher the premiums), the higher the yield on the legacy position would be. Eventually, when the cost basis is correct, the additional shares can be held and added to your share count, lowering your cost if the strategy is executed correctly.
Risks and Where I Could Be Wrong
I want to focus on the risks to Berkshire Hathaway as a company. I have focused on the risks particular to using derivatives throughout the article. Though the firm is known for being a quality company with quality management, the business model and its reliance on aging patriarchs is an enormous risk. I would say that succession is a primary risk, and while Buffett has named an able successor, it's always a question of whether or not the market will continue to see the magic.
Berkshire is exposed to its underlying businesses, so if another calamity in China led to a dramatic interruption in iPhone production, this catalyst of a significant holding could also hurt a major holder like the stalwart conglomerate. The insurance business model also exposes Berkshire to many of that business's risks. Insurance is a tricky business with rising instances of wildfires and other strange events. Despite high barriers, it is also increasingly subject to disruption by new entrants and technologies.
Technovert
Furthermore, despite the pristine reputation Mr. Buffett has rightfully acquired over the years, let's not forget he's in an inherently risky business. There are a lot of risks, and Berkshire has gotten so big that it is very exposed to macroeconomic weakness. While Mr. Buffett recently took a high-profile trade in treasuries that could offset losses in stocks, in the rare event that rates rise simultaneously as stocks decline for a prolonged period, like 2022, it could hit Berkshire hard.
It's important to remember that Berkshire has about the same probability of going bankrupt as Wells Fargo (WFC) according to some sources, as shown above. That fact may not be intuitively apparent given their respective reputations, particularly among those interested in stocks.
Conclusion
Berkshire is a legendary name with a good balance of diversification and safety. However, it can lag behind its peers, and a fundamental weakness of the stock is that it lacks a dividend. Thus, it cannot benefit from compounding that can lead so many investors to be able to beat the market over long periods reliably. For this reason, I think it is a prime candidate for using derivatives to create synthetic dividends. The key to the strategy I'm proposing is to use these proceeds to increase your share count and to repeat the strategy consistently over a long period.
It's hard to think of a stock with management I'm more confident in and trust. Still, risks are inherent to Berkshire's business and its growing size. Succession issues and how the market will receive new leadership will also be an issue that will come into view sooner or later, but hopefully later.
The immense strengths of Berkshire's advantageous stock portfolio and extensive business activities can potentially be complimented by a synthetic dividend that is reinvested in its shares. Though these proposed strategies can be time-consuming and subject to liquidity, execution, and transaction/tax risk, I am firmly convinced they can create alpha if competently executed over a sufficient period.
For further details see:
2 Strategies For Creating A Synthetic Dividend On Berkshire Hathaway Stock