There is an awful lot to be said for buying a bunch of Berkshire stock then sitting on your hands.
But it’s not the only way to go.
As many might know, I trade fairly frequently, resizing my position regularly in proportion to how I see the valuation level.
And also in proportion to how much money I have to invest…other things going on in my life.
The swing was particularly pronounced so far this year. My share count has doubled since its low earlier this year on March 27 when P/B was over 1.58.
The reason for the post is this interesting result:
Just checking my Berkshire trade records, I see that I have almost exactly the same number of shares today as I had 2012-02-29, a little over 10 years ago.
My average cost per share at that time was $73,097 after all trading costs.
It is now -$21,036 per share.
In effect, I have withdrawn and spent $94,134 per share without changing my share count.
The share price as a little under $118 on the starting day.
The drop arises from the benefit of ratcheting the breakeven cost down by repeated buying low(er) and selling high(er),
netted out with an offsetting rise in breakeven from the cost of all the option premiums and commissions I’ve paid. Commissions were about $51 per share.
The figures above therefore account for the cost of, but not benefit from, the leverage from call options.
So, position sizing now?
Price to peak book is still not a bad metric.
We’re at 1.305.
That figure will probably be above 1.45 again soon enough.
It has never taken more than 3.3 years to hit that multiple figure in the past, and we’re about 0.3 years in…
Returns from now till then will be roughly value growth plus a one-time 11% bump.
My central expectation for one year stock price return is in the vicinity of inflation + 12%.
If inflation is 4% (ha! who knows?) that would be a midpoint guess of around $526k per share.
I don’t know what the number will be. I expect that you don’t either : )
The high figures are in the past. The future is uncertain.
I picked 4% pretty arbitrarily, for the following reasons:
I’ve had it in my spreadsheet for quite a while–a very solid reason.
Unnoticed by most, the broad US money supply has been rising more slowly than 4%/year for a full two years now so there is no longer any monetary impulse.
There are other things going on, as inflation is high almost everywhere, but that was probably a big factor.
For someone considering whether a Berkshire call option might be a sensible price and end up profitable,
it’s the nominal price at the end that matters, not the price in inflation-adjusted dollars.
Choosing a low forward inflation estimate gives the most conservatism–it makes a call option purchase look like a poorer deal.
A call buyer today will be pleasantly surprised if inflation is higher than their assumption…the implied interest rate will turn out to have been lower.
Note, none of those reasons is “I think 4% is the right number”.
It’s better to pencil in a bad guess to throw up your hands and assume no inflation.
Jim,
Thank you for your post and all of your posts!
I was curious if you had a model for position size based on price to peak book value?
For example
50% at ratio between 1.5-1.6
100% at ratio less than 1.2
etc………
Thanks for all the Berkshire thoughts and information you have provided over the years Jim. I’m also too dumb/scared to trade options, use leverage, etc, but I do like reading about your strategies.
I’m also too dumb/scared to trade options, use leverage, etc,
Hey, don’t be scared.
There are option strategies that are really wild, but the one I use generally isn’t:
It’s the same as taking out a bank loan to buy more shares than you otherwise could, say 2-3 times as many.
The interest rate is known in advance, prepaid, and the bank can’t call the loan during the term.
Think of it as a balloon note: assume you’ll simply buy those shares, paying back the loan, when the term is up.
Viewed that way, it doesn’t sound very esoteric.
It’s about 99% certain you can renew it for another two years after that, though the interest rate at that time isn’t known.
Handy to know if your investment thesis hasn’t worked out yet after two years.
This works pretty well, but you’d only want to do it when there’s a good chance of something nice happening in the next 2-4 years.
Not when Berkshire is more expensive than usual. Borderline at best when it’s at average valuations, depending on interest rates.
But quite true any time it’s substantially cheaper than average. I bought a lot in June.
Thank you for your post and all of your posts! I was curious if you had a model for position size based on price to peak book value? For example 50% at ratio between 1.5-1.6 100% at ratio less than 1.2 etc………
Sure. I do love my spreadsheets and simulations.
I have found what would have been optimal in the past, but the overtuning is largely a waste of time: who knows what the future will bring?
Maybe it will trade over 1.7 times book for years. Maybe it will trade below 1.3 for years.
But there is no need to be precise.
We all know 1.2 is dirt cheap and it’s time to back up the truck.
We all known 1.6 isn’t likely to last long.
I did test one “system”:
Start off holding plain stock.
If the P/B gets below 1.35, sell some stock and buy calls to add leverage, say 1.5:1 overall.
e.g., sell half your stock and use the proceeds to buy options that have 2-to-1 leverage built in,
so you have control of 1.5 times as many shares with the same portfolio value.
Keep that leverage on until the next time P/B is 1.55 or higher. At that time, sell all options and put all proceeds into plain stock.
Repeat.
(Note, I use ratio of current price to “peak to date” book per share. Dips in book are assumed to be transient).
Since 1998 this would have resulted in the following trades:
Add leverage 2000-01-31 at price 51200 and P/B 1.341
Remove leverage 2000-04-20 at price 59700 and P/B 1.563 , stock CAGR since last change 76% High number = good time to have had leverage
Add leverage 2008-10-27 at price 105126 and P/B 1.348 , stock CAGR since last change 7%
Remove leverage 2014-12-02 at price 224805 and P/B 1.555 , stock CAGR since last change 13% High number = good time to have had leverage
Add leverage 2015-08-21 at price 201330 and P/B 1.345 , stock CAGR since last change -15%
Remove leverage 2017-02-22 at price 254415 and P/B 1.553 , stock CAGR since last change 17% High number = good time to have had leverage
Add leverage 2018-05-29 at price 284805 and P/B 1.345 , stock CAGR since last change 9%
Remove leverage 2022-03-24 at price 528555 and P/B 1.555 , stock CAGR since last change 18% High number = good time to have had leverage
Add leverage 2022-05-12 at price 462090 and P/B 1.338 , stock CAGR since last change -94%
Holding leverage 2022-07-29 at price 450900 and P/B 1.305 -- pudgy lady hasn't sung yet
Since valuation multiples are very much lower on average since the credit crunch, the optimum cutoffs have been sliding as well.
But this specific set of numbers would definitely have done very nicely through the years.
Note, it can be a very long wait for 1.55. You might have to roll the options once or twice, since you can’t get more than a couple of years at a time.
Thanks Jim. You mentioned that when the P/B gets to 1.55, you sell the options. The assumption being, it has now become a bit pricey…however, I noticed that you do not just sell and wait on the sidelines for a better/ opportune buy, and just convert the options into shares.
So, if and when the share prices fall, would that not “artificially/ temporarily” reduce the portfolio value? I am assuming you don’t simply stay and wait in cash at those times when P/b is pricey, because there is no way to perfectly time the market (i.e, the stock may continue to advance and we may not be able to buy back if rigidly waiting for it to fall). Is that right?
But with regards to the stock prices falling, again I am guessing that is exactly what you want (And Mr. buffet as well!)
You have no qualms in the share prices falling , because then it allows you to buy the stocks and the leverage again, and then rinse and repeat.
Thanks for generously sharing your time and wisdom.
Just checking my Berkshire trade records, I see that I have almost exactly the same number of shares today as I had 2012-02-29, a little over 10 years ago. My average cost per share at that time was $73,097 after all trading costs. It is now -$21,036 per share.
I don’t understand your calculation. How can cost basis of your shares be negative? It seems impossible. I understand that you made large profits (realized gains) from trading in and out of your Berkshire shares/options over the last 10 years, and that you are now left with exactly the same number of shares as you started with in 2012. But surely, the cost basis of your current shares cannot be negative?
Thanks Jim. You mentioned that when the P/B gets to 1.55, you sell the options. The assumption being, it has now become a bit pricey…however, I noticed that you do not just sell and wait on the sidelines for a better/ opportune buy, and just convert the options into shares. So, if and when the share prices fall, would that not “artificially/ temporarily” reduce the portfolio value?
Remember that these numbers are valuation multiple levels, not price levels.
The price can rise steadily without the valuation ever getting very high or very low.
As a result, you can’t reliably sell at a given rich price and know you’ll ever get back in again at a lower price.
I don’t know of any way to create a trading system that would make that work.
The problem is this:
Maybe the stock gets expensive, then stays flat while the value grows into it: you sell at a rich valuation, waiting for a lower re-entry price, and wait forever.
Sitting in cash forever won’t get you much of a return.
We can’t predict prices; all we can predict is that if it’s unusually cheap, then it makes sense to pile on some more till the next time it isn’t unusually cheap.
The absolute price may be unpredictable, but it’s pretty predictable that the valuation multiple won’t stay unusually cheap forever.
So, the general idea of the scheme is this:
First, hold the stock all the time as a general rule.
It rises in value over time, it’s a good long term investment, and we don’t know what will happen to the share price in the short term so a long term hold makes the most sense.
Your baseline long run return is the long run return of the stock. Not so bad.
But also, if it occasionally gets unusually cheap, add some extra as a temporary situation.
If you keep that “extra” position until the next time the valuation level is good, you’ll have made a good bonus return with low risk.
It might be a little while later, it might be 3-5 years, but eventually the valuation level will be reasonable again.
End the “extra” position then. During that stretch, the extra position will get the value growth of the shares plus the expansion in multiples.
Those two combine to be a pretty compelling opportunity as a rate of return, so it’s worth the extra allocation…even with (say it softly) leverage from call options.
Any chance of adding a metric for capital gains tax showing how that would change the bottom line for us mere mortals?
Sorry, no, though I think that table has pretty much everything you’d need to work it out by pencil.
There are only 9 transactions.
As a crude rule of thumb, assume you can buy call options offering 2:1 leverage with two years to run for a premium of 6%/year on the leverage.
(= 3%/year on the number of shares controlled)
If you sell half your stock to buy 2:1 options, the cost on your portfolio would be around 1.5%/year of your starting portfolio value.
The US situation is always complicated. Most countries don’t distinguish between long and short term capital gains taxes, for example.
I don’t understand your calculation. How can cost basis of your shares be negative? It seems impossible.
It may be a terminology issue.
I don’t pay tax, so cost basis has nothing to do with what I paid for a given specific share or how long I’ve owned it or the order of my purchases and sales.
I just own a single amorphous block of shares that I put money into. And sometimes took money out of.
For me, my cost basis per share is average NET cost per share of my current position:
The total amount of money I’ve put into purchases of that stock, minus the cash raised by any sales, divided by the number of shares I own today.
(This is, incidentally, also the method used for taxable cost basis in some countries)
If I trade small amounts, buying low and selling high repeatedly, I’ll make a profit from that process over time.
If I withdraw those profits and spend the money rather than letting the number of shares rise,
then my cost basis per share still owned (only as defined above) will fall over time without limit.
Looked at another way:
If Berkshire went bust and the stock went to zero tomorrow, my all-time start-to-finish profit on Berkshire would still be substantially positive.
That can be true only for people with a negative net cost basis per share: they own shares, but they have taken more out of the position than they’ve put in.
I have no remaining skin in the game.
It’s not that rare or difficult–it depends on position sizing.
For example, say you buy 1000 shares of XYZ at $10 for a total cost of $10000, then sell 990 at $11 for total proceeds of $10890.
Your total net cost to date of your remaining 10 share position is -$890 or -$89.00 per share.
Is that meaningful? Sure. That’s your final start-to-finish profit if the company went bust tomorrow.
For any positive cost basis, that’s how much you lose if the stock is a zero.
If something going to zero leaves you with a profit, your net cost basis that day had to have been negative : )
Thank you for these outstanding posts and sharing your wisdom. I have been dipping my toes into some DITM LEAPS options (better than dice and Blackjack!). What % of the time do you sell the option itself for profit vs. actually fulfilling the purchase of 100 shares/ contract?
Appreciate any insight into your thinking when this decision time occurs. Thanks Jim!
Jim, you ruined it. Mid-June I bought Jan’24 Calls. Since then I am waiting for Mid’24 Calls coming out to buy those - - - but now I will have to buy them at “Jim’s Newsletter said …” prices
Kidding off.
Thanks for your newsletter and thanks for it not coming out only on a monthly basis, and for keeping the subscription price low.
Anybody any idea when those Mid’24 Calls will be available for BRK? I am waiting since quite a while now, getting frustrated while the stock price is rising.
Thanks for all the Berkshire thoughts and information you have provided over the years Jim. I’m also too dumb/scared to trade options, use leverage, etc, but I do like reading about your strategies.
His information about using long-dated DITM call options on BRK are great. As synthetic leverage. Once you understand the math. The implied interest rate is still too high right now, IMHO. It’s usually around 3% but now it’s 6%-7%.
Gives you plenty of time to work out and understand the math.
The price/book is quite low right now, reported as 1.25 to 1.31. From that aspect it seems like a good time to do it.
As a crude rule of thumb, assume you can buy call options offering 2:1 leverage with two years to run for a premium of 6%/year on the leverage. (= 3%/year on the number of shares controlled) If you sell half your stock to buy 2:1 options, the cost on your portfolio would be around 1.5%/year of your starting portfolio value. ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ RVT: The implied interest rate is still too high right now, IMHO. It’s usually around 3% but now it’s 6%-7%.
I’d like to better understand the role of fluctuating interest rates on the timing of option buys. I thought Jim’s mention of a 6% premium/year on the leverage was referring to this.
