The Tycoon Report
Warren Buffett's Favorite Options Strategy
Monday, October 13, 2008 | Marie Albin

Warren Buffett isn’t known for his risky investments. Berkshire Hathaway’s portfolio is filled with blue-chip value plays like General Electric (GE), Coca-Cola (KO), and Procter & Gamble (PG).

So it may surprise you that Warren Buffett is one of, if not THE, single biggest individual options traders in the world.

Just this week, Warren Buffett’s Berkshire Hathaway disclosed that it has written put options on railroad stock Burlington Northern Santa Fe Corp. (BNI). Buffett is using this options strategy as a way to add to his shares of Burlington Northern.

You may recall that Chris Rowe told Tycoon readers about this strategy in his article, "Profit from the Bailout Bloodbath". Chris pointed out that selling naked puts (or writing put options) is a great way to buy stock as well as collect a premium, especially in this market environment. If you missed his article, be sure to check it out. 

[Editor's Note: To learn more about trading options, go here to get Chris' free report, Options Made Simple.]

Clearly, Buffett agrees. Buffett’s Berkshire Hathaway has sold put options that will force it to purchase 3.26 million BNI shares between $77 and $80 a share.

On Oct. 6, Berkshire wrote put options for 1.39 million shares of BNI at a premium of $7.02 per contract. The put option is exercisable until Dec. 9 at a strike price of $80.

On Oct. 9, Berkshire wrote put options for 1.19 million shares at a premium of $7.03 per contract, and another for 761,111 shares at a premium of $5.78 per contract. The put options are again exercisable on Dec. 9 with a strike price of $80 for the 1.19 million shares and at $77 for the 761,111 shares.

Buffett pocketed a premium of $22 million for writing the options contracts, which he can then put toward buying the shares that he very likely would have bought anyway. 

Buffett already owns more than 63.7 million shares of Burlington Northern, according to SEC filings. That’s about an 18% stake in the railroad company.

According to GuruFocus.com, Buffett bought shares of Burlington Northern at an average price of about $80 a share, which is, not surprisingly, the price that Buffett is targeting. As of Friday’s close, BNI shares were trading at $80.16 a share. BNI shares hit a peak of $114.58 in June.

[Editor's Note: What do you think about selling naked puts? Have you used this strategy to buy stock?]

(Please let us know what you think about Marie Albin's article.)
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Marie Albin
Chief Investment Officer
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Economic Calendar for the week of October 13 to October 17

Wednesday, Oct. 15

8:30 Producer Price Index (PPI)

The Producer Price Index measures prices of goods at the wholesale level. There are three broad subcategories within PPI: crude, intermediate, and finished. The market tracks the finished goods index most closely, as it represents prices for goods that are ready for sale to the end user. Goods prices at the crude and intermediate stages of production often provide an indication of coming (dis)inflationary pressures, but the closer you get to crude goods, the more that these prices track commodity prices which are already available in traded indexes such as the CRB (Commodity Research Bureau).

At all stages of production, the market places more emphasis on the index excluding food and energy, referred to as the core rate. Food and energy prices tend to be quite volatile and obscure trends in the underlying inflation rate. Though the market reaction is determined by the month/month changes, year/year changes are also noted by analysts. The index is not revised on a monthly basis, but annual revisions to seasonal adjustment factors can produce small adjustments to past releases.

Big Picture

The Big Picture here is not that complicated. The outlook for total PPI depends heavily on the trend in commodity prices. Those are very hard to predict. Core prices will be influenced by commodity prices as well, as evident in recent data. But weak demand will keep core prices relatively in check. Whether higher PPI prices can be passed along into CPI is questionable, given weak final demand. There will be pressures, obviously, but the outlook for consumer prices also depends heavily on commodity price trends.

8:30 Retail Sales

The retail sales report is a measure of the total receipts of retail stores. The changes in retail sales are widely followed as the most timely indicator of broad consumer spending patterns. Retail sales are often viewed ex-autos, as auto sales can move sharply from month-to-month. It is also important to keep an eye on the gas and food components, where changes in sales are often a result of price changes rather than shifting consumer demand.

Retail sales can be quite volatile and the advance reports are subject to rather large revisions. Retail sales do not include spending on services, which makes up over half of total consumption. Total personal consumption is not available until the personal income and consumption reports are released, typically two weeks after retail sales.

Thursday, Oct. 16

8:30 Consumer Price Index (CPI)

The Consumer Price Index is a measure of the price level of a fixed market basket of goods and services purchased by consumers. CPI is the most widely cited inflation indicator, and it is used to calculate cost of living adjustments for government programs and it is the basis of COLAs for many private labor agreements as well. It has been criticized for overstating inflation, because it does not adjust for substitution effects and because the fixed basket does not reflect price changes in new technology goods which are often declining in price. Despite these criticisms, it remains the benchmark inflation index.

CPI can be greatly influenced in any given month by a movement in volatile food and energy prices. Therefore, it is important to look at CPI excluding food and energy, commonly called the "core rate" of inflation. Within the core rate, some of the more volatile and closely watched components are apparel, tobacco, airfares, and new cars. In addition to tracking the month/month changes in core CPI, the year/year change in core CPI is seen by most economists as the best measure of the underlying inflation rate.

9:15 Industrial Production

The index of Industrial Production is a fixed-weight measure of the physical output of the nation's factories, mines, and utilities. Manufacturing production, the largest component of the total, can be accurately predicted using total manufacturing hours worked from the employment report. One of the bigger wildcards in this report is utility production, which can be quite volatile due to swings in the weather. Severe hot or cold spells can boost production as increased heating/cooling needs drive utility production up.

In addition to production, this monthly report also provides a measure of capacity utilization. Though the rate of capacity utilization is seen as a critical gauge of the slack available in the economy, the market does not completely trust this measure. Capacity is very difficult to measure, and the Fed essentially assumes that growth in capacity in any given year follows a straight line. One can therefore predict the capacity utilization rate quite accurately based on the assumption for production growth. The 85% mark is seen as a key barrier over which inflationary pressures are generated, but given revisions to these data and the difficulties with capacity measurement, the 85% mark should be viewed cautiously. It would be appropriate to look for corroborating inflation indications from commodity prices and vendor deliveries.

Big Picture

Surprising resilience in manufacturing is a major reason the period of weak economic growth late last year and early this year did not turn into a recession.  Industrial production in July was flat with the year-ago level.  In recessions, production tends to drop sharply to well below year-ago levels.  For example, just prior to the 2001 recession and through 20021 and into early 2002, industrial production fell every single month.  Fourteen straight monthly declines were posted, with an average decline of 0.5% per month.  Year-over-year production fell to -5%.  This cycle, there have been monthly declines and a leveling off in production, but that reflects considerable resilience relative to the 2001 recession. 

10:00 Philadelphia Fed Index

There are many regional manufacturing surveys, and they tend to be ranked in order of timeliness and the importance of the region. The Philadelphia Fed's survey is first each month, actually coming out during the third week of the month for which it is reporting. Several smaller surveys are then released before the Chicago purchasing managers' report on the last day of each month. A few, such as the Atlanta and Richmond Fed surveys, are released after the NAPM and are of little value. The purchasing managers' reports are measured like the national NAPM - 50% marks the breakeven line between an expanding and contracting manufacturing sector. For the Philadelphia and Atlanta Fed indexes, 0 is the breakeven mark.

These surveys can be of some help in forecasting the national NAPM - particularly the Philadelphia and Chicago surveys which are more closely watched due to their timeliness and the fact that these regions represent a reasonable cross section of national manufacturing activities.

 

Friday, Oct. 17

8:30 Housing Starts and Building Permits

Housing Starts are a measure of the number of residential units on which construction is begun each month. A start in construction is defined as the beginning of excavation of the foundation for the building and is comprised primarily of residential housing. Building permits are permits taken out in order to allow excavation. An increase in building permits and starts usually occurs a few months after a reduction in mortgage rates. Permits lead starts, but permits are not required in all regions of the country, and the level of permits therefore tends to be less than the level of starts over time.

The monthly national report is broken down by region: Northeast, Midwest, South, and West. Briefing recommends analyzing the regional data because they are subject to a high degree of volatility. The high volatility can be attributed to weather changes and/or natural disasters. For example, an unexpectedly high level of rain in South could delay housing starts for the region.

Big Picture

The housing sector has been in a deep recession.  Fortunately, there are now some signs that the rate of decline is slowing, and even that some stabilization is occurring.  The rate of decline in existing home sales has slowed over the past half year.  Sales are not picking up, but a bottoming is preceded by a leveling off.  Now, housing starts and permits are starting to level off as well.  It may well be that the housing sector stabilizes over the summer months, and picks up in the third quarter.  Lower mortgage rates and a stabilizing economy will help.  Lower prices on homes will ulitimately stimulate demand, but for now may inhibit sales as the urgency to buy is mitigated.  The housing sector is a long way from anything that can be called a recovery, but even a general stabilization would help boost GDP numbers by eliminating what has been a major negative on the numbers the past year. 

10:00 University of Michigan Consumer Sentiment Index

The Michigan index is almost identical to the Conference Board Consumer Confidence index, though there are two monthly releases, a preliminary and final reading. Like the Conference Board index, it has two subindexes - expectations and current conditions. The expectations index is a component of the Conference Board's Leading Indicators index.

Big Picture

Consumer sentiment surveys get way too much attention.  Right now, the surveys are greatly influenced by the price of gasoline.  Gasoline represents only 4% of consumer spending, and price changes don't have nearly as much impact on consumer spending power as generally thought, but gas prices have a huge impact on sentiment.