From the very beginning (when Buffett took over), Berkshire was built around the insurance business with the purchase of National Indemnity Co. in the late 1970s. The great thing about insurance businesses is they tend to be highly profitable and capital light, so return on capital invested is high. As well as throwing off plenty of cash, insurance companies have what is called a float, which simply put is retained profits held back to pay out any losses stemming from customer claims.
With the investment pool and insurance business working together, insurance companies can essentially achieve a double return on invested capital. Most insurance groups, however, invest their float defensively in fixed-income securities to reduce the possibility of loss. If an insurance company cannot meet loss obligations stemming from underwriting activities, it will very quickly go out of business, which is why insurance managements tend to adopt this defensive approach.
Confident in his own investing ability, Buffett has been using the float to generate excess returns for Berkshire Hathaway ever since acquiring his first insurance business.
Unfortunately, this strategy is not available to most investors, but one hedge fund manager has put together his own plan that utilizes the same kind of investment structure.
Replicating Buffett’s strategy
Last year, I interviewed Chris Abram of CVA Investment Management for ValueWalk.com. Abram uses an investment strategy that combines options and equities. He runs a sort of insurance book, generating a float by selling options and invests in equities on the site. Here are some extracts from the interview:
Q: So you write options to generate income and grow the float?
CA: "Exactly. The vast majority of options trading is on ETFs, and most of that is short-term trading, for hedging and speculating. Because most traders concentrate on these limited markets, there is very little attention focused on longer-term options of individual companies. A lot of institutional investors just cannot invest in this sector because their investment mandates will not allow it and hedge funds are only interested in the short-term use of options to hedge positions."
Q: One of the key caveats of value investing is minimising risk. Options trading is known for its high level of risk…
CA: "I think options trading is perceived as higher risk, but it all comes down to the underlying stock. I think the real risk stems from a lack of knowledge about option pricing and stock valuation. As we know, a stock price will fluctuate much more than the underlying business. This stock volatility leads to some extreme volatility in options pricing, which translates into more opportunities for the options investor."
Q: What’s your investment timeframe?
CA: "Generally, I invest on a one to two-year timeframe with regard to options since those are the longest term options widely available on the market. The reason why I have chosen this time frame is because those are the options that are generally the most mispriced."
Q: Could you guide us through your investment process?
CA: "Sure, let’s say a stock is trading at $100 and under my valuation, I believe it’s worth $130 to $150. If I can sell puts at $85 and collect $8 in premium, a premium that expires in one year, to me that would be very attractive. In this scenario, my net buy price, if I were forced to buy, would be $77, otherwise the options will expire and I get to keep the float."
Q: When you’re looking at plays like this, do you tend to stick to defensive sectors or branch out into the more cyclical sectors which may offer a greater return but a higher level of risk?
CA: "I tend to stick with defensives because with cyclicals the volatility can be quite aggressive and you can really get hurt there. But I would be inclined to buy cyclicals if they were cheap enough and they had a competitive advantage over peers. Although if I did go down that route, I would buy long-term LEAPs to cap my downside, while leaving me exposed to a long-term cyclical recovery."
Q: So your advice would be to find the stock, calculate the value, buy as a value investment and then look at the options?
CA: "Exactly. Since your 'collateral' is the underlying business, you need to gain a firm foundation in fundamental research to understand what it is worth. Once you have established a valuation range and a margin of safety, you have more flexibility in understanding which options to use. To me, it is easier if you understand the valuation first and then the derivatives. It is a much simpler and straightforward approach."
Disclosure: The author owns no stock mentioned.
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