Warren Buffett is widely considered to be one of the most successful investors of all time.
He started investing in stocks at the age of 10, and was a millionaire by his early 30s, when he started buying Berkshire Hathaway stock at $7.60 per 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 unexpected prospects and strong management. Then he 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 No.2: Never forget rule No.1.”
But there are three lesser-known tactics that Buffett used to build his fortune that savvy investors may want to borrow—even if they sometimes go against his most famous investment strategies.
1. Put options to sell
You’d think someone like Buffett dedicated to blue chip stocks would emerge from complex derivatives, but you’d be wrong.
Throughout his investing career, Buffett used the advanced options trading technique of selling put options as a hedging strategy. In fact, in Berkshire Hathaway’s 2007 annual report, the company admitted to having 94 derivative contracts, which generated $7.7 billion in premiums during the year.
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 immediately gives you money from the sale of the option. If the share price does not fall, you keep the money.
If the price falls below the strike price, you buy the stock for less than you would have paid when you sold the option, and the proceeds from the sale of the option will further reduce your cost basis. This is a good strategy for a stock you don’t mind owning in the first place. In 1993, Buffett used options to pocket nearly $7.5 million in income while waiting for Coca-Cola’s share price to decline.
The option is considered “exposed” because you have not received an alternative to buying the stock, such as shorting shares of that same stock to offset your purchase cost.
But keep in mind that this is in view of the risk involved, that this is not something that a newbie investor should try on their own.
2. Invest in small cap stocks
When you’re throwing around the kind of cash that’s measured in billions, shares of promising emerging companies won’t do well. Shares of small-cap growth stocks of companies typically worth $300 million would move them to $2 billion too much if Oracle Omaha made a purchase big enough to make it worth its while.
“I have to look for an elephant,” Buffett once said when discussing his investment options. “Perhaps the elephants are not as attractive as the 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 the so-called “mosquitoes” are attractive is because shares show the greatest growth in the early days of a company’s operation. But just because those small 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 stretch to the point where he doesn’t even admit it sometimes. As soon as losses come in at a well-managed company, that is a sign that the economics of that business may have changed in a way that will create losses for the foreseeable future.
For Buffett, his recent bad move was investing in airline companies. At one time Berkshire Hathaway owned all four major American airlines: Delta, American Airlines, Southwest and United. Although he only added these companies to his roster in 2016, by the end of 2020, he had dropped them all – a fairly large loss.
Buffett took responsibility for the failed strategy, but it was clear that he did not see a future in the airlines and even went so far as to call the industry “pitless bottom”.
“We will not finance a company – where we think it is going to chew 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. It is provided without warranty of any kind.