Is This Buffett's Secret to 50% Returns?
In 1999, Warren Buffett famously said that if he only had a mere $1 million to invest, he could guarantee 50% annual returns. That's an incredible hurdle to beat, especially with a guarantee attached, since the overall market generally sees returns closer to the neighborhood of 8% to 10% on average, with losses common.
Still, it's an interesting challenge to try to figure out a strategy that had a legitimate shot of meeting Buffett's 50% hurdle. About a year ago, I set out to try, with far less than $1 million to invest, but with a strategy that I thought had an outside shot of reaching Buffett's elusive 50% return rate.
During that year, the strategy succeeded far beyond my wildest dreams. I had a gain of a bit better than 75% on my invested cash, and because I deposited money at a few different times, Excel calculates my overall internal rate of return for the year as being above 100%, both before tax. Still, as you'll soon see, as fabulous as that year was, it took a lot of risk to get there, and the account is not likely to continue that incredible run.
The strategy -- and its risks
The core of the strategy involves writing options positions known as short strangles, built by selling an out-of-the-money call and an out-of-the-money put on the same stock. In this implementation, the upside risk was covered by a synthetic long, and the downside risk was left exposed, in the belief that a decent valuation on the underlying stock helped mitigate that downside risk.
Indeed, thanks to adding the short put option part of the synthetic long with the short put from the strangle position, the account was exposed to twice the downside risk of mere stock ownership. Add the fact that the account leaned on its margin abilities to open positions, and it could have been stuck with a loss that exceeded the total amount of cash invested in it.
In fact, while the strategy ultimately worked, I did face a handful of margin calls and had a couple of stocks put to me. Were it not for the incredible luck of having a tailwind of a rising market lifting darn near everything skyward, I would likely have lost a significant chunk of money. And since the market is so much higher now than it was a year ago at this time, it's significantly harder to find stocks that look like compelling enough values to justify the risk of the double downside exposure the strategy relies on.
Because of all that incredible risk and luck involved, although the strategy did let me beat Buffett's 50% return target for a year, I don't believe it's anywhere near a sustainable, much less guaranteed return.
How Buffett inspired it
Still, while the strategy may not sound much like the type of investing Buffett is best known for, it was inspired by him.
For instance, Berkshire Hathaway , the company Buffett runs, is an insurance business. Berkshire Hathaway gets paid up front in the form of insurance premiums in order to take on financial risks. When setting up a short strangle position, I get paid a premium up front to take on the risk of volatility.
Similarly, while the synthetic long part of the position was a form of insurance on the stock running up too high, I could often pick up a credit on opening it, especially if the company paid dividends. For instance, the screen capture below shows the opening transaction on an options position I held in Goldman Sachs . Note the $19.02 credit for opening the January 2014 short put against the $16.28 charge for opening the January 2014 long call that made up the synthetic long:
And lest you think Buffett wouldn't engage in crazy things like options trading, note that Buffett himself has sold billions of dollars worth of put options at Berkshire Hathaway, often to Goldman Sachs. Indeed, you can even make the argument that by selling put options while carrying over $60 billion in debt on Berkshire Hathaway's balance sheet, Buffett is doing a close corporate analog to leaning on margin to write those puts.
Finally, the strategy was also inspired by the more classic view of Buffett as a value investor looking to pick up bargains. The reason this strategy had an opportunity to profit was because it left the downside risk wide open, and in fact magnified it. That's a crazy thing to do in an options strategy, yet it was a little less crazy if there was good reason to believe the underlying stock was undervalued by the market.
What went wrong?
In spite of the fact that the overall strategy worked out over the course of a year, it wasn't consistently smooth sailing. I did have to manage around a handful of margin calls -- including one where Hurricane Sandy shut down the market, but not the timer that determined when I had to make good on the call.
Additionally, this strategy requires regular maintenance to roll forward the strangle positions. On two occasions, the combination of a down stock and evaporated time values prior to expiration meant that I had the shares put to me before I could roll forward the contracts. As a result, I now own shares of freight company Arkansas Best and gold miner Harmony Gold .
While Arkansas Best has since recovered, in large part thanks to merger talks, Harmony Gold remains weak. Some of that weakness can be traced to the falling price of gold, but much of it has to do with the miner's internal problems, including violence and labor strife at a key South African mine. Time will tell whether Harmony Gold gets its operations in order, but in the meantime, it certainly shows just how real the downside risks are in this strategy.
In a Foolish nutshell...
To put it all together, this strategy did beat Buffett's 50% annual returns target for one year, and while it's inspired by Buffett, it's almost certainly not the way he'd go about guaranteeing such returns. The risks are huge, the upsides capped, and the reliance on the market behaving just right is too large to come anywhere close to a reliable market-trouncing strategy.
It was certainly fun and profitable to try to figure out how Buffett could guarantee 50% annual returns, but for now, that secret remains Buffett's.
If you can't beat Buffett, invest like him
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The article Is This Buffett's Secret to 50% Returns? originally appeared on Fool.com.Fool contributor Chuck Saletta owns shares of Arkansas Best and Harmony Gold. Chuck also has options positions in Arkansas Best and Harmony Gold. The Motley Fool recommends Berkshire Hathaway and Goldman Sachs. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.