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Berkshire Hathaway Inc. (BRK.A), Goldman Sachs Group, Inc. (GS): Is This Buffett’s Secret to 50% Returns?

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Warren Buffett Coca-Cola Company (KO)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 Inc. (NYSE:BRK.A), the company Buffett runs, is an insurance business. Berkshire Hathaway Inc. (NYSE:BRK.A) 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 Group, Inc. (NYSE:GS). 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:

Is This Buffett's Secret to 50% Returns?Screen capture from author’s brokerage account.

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 Group, Inc. (NYSE:GS). Indeed, you can even make the argument that by selling put options while carrying over $60 billion in debt on Berkshire Hathaway Inc. (NYSE:BRK.A)’s balance sheet, Buffett is doing a close corporate analog to leaning on margin to write those puts.

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