Warren Buffett is widely regarded as one of the most successful investors of all time.
He started investing in stocks at age 10 and was a millionaire by 30 when he started buying Berkshire Hathaway stock at $7.60 a share. Today, Berkshire trades at around $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. He then holds those shares for years, if not decades. The secret of his success, he says, is to follow two rules:
“Rule No. 1: Never lose money. Rule #2: Never forget rule #1.
But there are three lesser-known tactics Buffett used to build his fortune that savvy investors may want to borrow — even if they sometimes conflict with his better-known investing strategies.
1. Selling options
You’d think someone like Buffett who seems devoted to blue-chip stocks would shy away from complicated derivatives, but you’d be wrong.
Throughout his investing career, Buffett has leveraged the advanced options trading technique of selling bare put options as a hedging strategy. In fact, in Berkshire Hathaway’s 2007 annual report, the company acknowledged that it had 94 derivative contracts, which during the year generated $7.7 billion in premiums.
This strategy involves selling an option where you promise to buy a stock at a specific strike price below its current value at some point in the future. This gives you immediate money from selling the option. If the stock price doesn’t go down, you keep the money.
If the price falls below the strike price, you buy the stock for less than what you would have paid when you sold the option, with the cash from selling the option further reducing your cost basis. This is a good strategy for a stock you wouldn’t mind owning in the first place. In 1993, Buffett used put options to earn nearly $7.5 million in income while waiting for Coca-Cola’s stock price to fall.
The option is considered “bare” because you have not secured another option to buy the stock, such as shorting shares of the same stock to offset your purchase cost.
But keep in mind that this, given the risk involved, is not something a novice investor should try on their own.
2. Investing in small cap stocks
When you’re flying around the kind of cash that’s in the billions, picking up shares of promising emerging companies won’t work. Small-cap growth stocks of companies typically worth $300 billion to $2 billion would move wildly if the Oracle of Omaha made a purchase big enough to make it worthwhile.
“I have to look for elephants,” Buffett once said when discussing his investment choices. “Elephants may not be as attractive as mosquitoes. But that’s the universe I have to live in.”
Of course, it wasn’t always like that. Buffett began his career investing primarily in small-cap 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 reason these so-called “mosquitoes” are attractive is because stocks show the most growth in a company’s first few days of operation. But just because these little outfits are off limits to Buffett today, doesn’t mean you can’t go after them.
3. Cut losses when necessary
Buffett’s buy-and-hold approach doesn’t extend to never admitting that even he sometimes gets it wrong. Once losses appear in a well-run company, this is a sign that the company’s finances may have changed in a way that will create losses over a long period of time.
As for Buffett, his big mistake recently has been investing in airlines. Berkshire Hathaway once owned a stake in all four major US airlines: Delta, American Airlines, Southwest and United. While he only added these companies to his roster 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. Provided without warranty of any kind.