Investing Alongside The Oracle Of Omaha While Limiting Your Risk

 |  Includes: BRK.A, BRK.B, IBM, KO, PG, WFC
by: David Pinsen


You can invest in Berkshire Hathaway and its top holdings while limiting your risk by using a hedged portfolio, such as the one show below.

This portfolio has a negative hedging cost, meaning you would effectively be getting paid to hedge.

This portfolio is designed for an investor who is willing to risk a maximum drawdown of up to 10%.

Investors with higher or lower risk tolerances can use a similar process, though their potential returns may differ.

Investing Alongside The Oracle Of Omaha

In a recent article, we considered one source of ideas for a hedged portfolio: the buy list of a top finance blogger, Eddy Elfenbein of Crossing Wall Street. This time we'll consider another source of ideas, the top holdings of the "Oracle of Omaha", Warren Buffett, chairman of Berkshire Hathaway, Inc. (NYSE:BRK.B).

Being Prepared For Bear Markets

Even the holdings of the best investors can get hammered during bear markets. Our previous source of stock ideas for a hedged portfolio, Eddy Elfenbein, offered a stern warning for investors about bear markets on his blog:

Be prepared for bear markets. A lousy market can strike at any time without warning. All stocks go down. [...] Stocks are volatile by nature. That's the price you pay for superior returns. [...] If you can't bear to see your portfolio drop by 50%, do not invest in the stock market.

Elfenbein's warning should be heeded by unhedged investors, including those invested in shares of Berkshire Hathaway or some of its publicly-traded holdings. Investors who are willing to hedge, though, can invest in the stock market while limiting how much their portfolios will drop in the event of a bear market. Let's review some of the basics of hedged portfolios and then see how we can create one using Warren Buffett's Berkshire Hathaway and several of its holdings as a starting point, for an investor with $250,000 to invest, who is willing to risk a maximum decline of only 10%.

Risk Tolerance, Hedging Cost, and Potential Return

All else equal, with a hedged portfolio, the greater an investor's risk tolerance -- the greater the maximum drawdown he is willing to risk (his "threshold") -- the lower his hedging cost will be and the higher his potential return will be. So, we should expect that an investor who is only willing to risk a 10% decline will likely have a lower potential return than one who is willing to risk, say, a 20% decline.

Constructing A Hedged Portfolio

In a previous article ("Rethinking Risk Management: A New Approach To Portfolio Construction"), we discussed a process investors could use to construct a hedged portfolio designed to maximize potential return while limiting risk. We'll recap that process here briefly, and then explain how you can implement it yourself. Finally, we'll present an example of a hedged portfolio that was constructed this way with an automated tool. The process, in broad strokes, is this:

  1. Find securities with relatively high expected returns.
  2. Find securities that are relatively inexpensive to hedge.
  3. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high expected returns net of their hedging costs (or, ones with high net expected returns).
  4. Hedge them.

The potential benefits of this approach are twofold:

  • If you are successful at the first step (finding securities with high expected returns), and you hold a concentrated portfolio of them, your portfolio should generate decent returns over time.
  • If you are hedged, and your return estimates are completely wrong, on occasion -- or the market moves against you -- your downside will be strictly limited.

How to Implement This Approach

  • Finding promising stocks. In this case, we're going to start with Berkshire Hathaway itself (the B-shares in particular, because those can be hedged), and its top publicly traded holdings. Seeking Alpha contributor John Vincent included a handy spreadsheet of Berkshire Hathaway's top holdings in this article last month, "Tracking Warren Buffett's Berkshire Hathaway Portfolio - Q4 2013 Update". To quantify expected returns for Berkshire and its top holdings, you can, for example, use analysts' price targets for them and then convert these to percentage returns from current prices. In general, though, you'll need to use the same time frame for each of your expected return calculations to facilitate comparisons of expected returns, hedging costs, and net expected returns. Our method starts with calculations of six-month expected returns.
  • Finding inexpensive ways to hedge these securities. First, you'll need to determine whether each of these top holdings are hedgeable. Then, whatever hedging method you use, for this example, you'd want to make sure that each security is hedged against a greater-than-10% decline over the time frame covered by your expected return calculations (our method attempts to find optimal static hedges using collars as well as married puts going out approximately six months). And you'll need to calculate your cost of hedging as a percentage of position value.
  • Buying the securities with positive net expected returns. In order to determine which securities these are, out of the list above, you may need to first adjust your expected return calculations by the time frame of your hedges. For example, although our method initially calculates six-month expected returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our expected return calculation down accordingly, because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before their hedges expire or until they are called away, whichever comes first). Next, you'll need to subtract the hedging costs you calculated in the previous step from the expected returns you calculated for each position, and sort the securities by their expected returns net of hedging costs, or net expected returns.
  • Fine-tuning portfolio construction. You'll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs, so if you're going to include a handful of securities from the sort in the previous step and you have a relatively small portfolio, you'll need to take into account the share prices of the securities. Another fine-tuning step is to minimize cash that's leftover after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won't need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash you can potentially boost returns. In this step, our method searches for what we call a "cash substitute": that's a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor's downside limited according to his specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step.

An Automated Approach

Here we'll show an example of creating a hedged portfolio starting with Berkshire Hathaway and its top holdings using the general process described above, facilitated by the automated portfolio construction tool at Portfolio Armor. In the first step, we enter the ticker symbols for Berkshire Hathaway and its top holdings in the "Tickers" field. Those top holdings, as of the end of 2013, per John Vincent's update, were:

  • American Express (NYSE:AXP)
  • Coca Cola (NYSE:KO)
  • Exxon Mobil (NYSE:XOM)
  • International Business Machines (NYSE:IBM)
  • Procter & Gamble (NYSE:PG)
  • Wells Fargo (NYSE:WFC)

General Electric (NYSE:GE) was one of Berkshire Hathaway's smaller holdings, but we added it as well here, since the company is such a broad conglomerate.

In the second field, we enter the dollar amount of our investor's portfolio (250000), and in the third field, the maximum decline he's willing to risk in percentage terms (10). We leave the strategy in the fourth field set to its default, "Maximize Potential Return".

In the second step, we are given the option of entering our own return estimates for Berkshire Hathaway and each of its holdings we've entered. For this example, we'll leave these blank and let the tool use its own expected returns for these utility stocks.

A couple minutes after clicking the "Create" button, we were presented with this hedged portfolio. The data here is as of Tuesday's close (results may, of course, differ, depending on prevailing market conditions).

Why These Securities?

In its initial allocation, the tool included BRK.B and each of its holdings we entered. It included all of these stocks because it found that each had a positive expected return net of its hedging costs. In its fine-tuning step, the tool added Yelp (NYSE:YELP) as a cash substitute, due to its high net expected return and low hedging cost at a 10% threshold.

Each Security Is Hedged

Note that each of the above securities is hedged. Yelp, the cash substitute, is hedged with an optimal collar, with its cap set at 1%; the remaining securities are hedged with optimal collars with their caps set at each stock's expected return, as calculated by the tool. Here is a closer look at the hedge for Berkshire Hathaway itself:

The cap for Berkshire Hathaway was set at 5.75% here because that's the expected return the tool calculated for it. It used an optimal collar here rather than an optimal put because the position had a higher net expected return when hedged with a collar (the tool calculated the net expected returns both ways for each of the positions in the portfolio). As you can see at the bottom of the image above, the net cost of the hedge for the BRK.B position was $128, or 0.51% of the position value.[i]

Negative Hedging Cost

As you can see below in the summary for this hedged portfolio, the hedging cost of the entire portfolio (which includes the hedging cost of the BRK.B position above) was negative: an investor would have collected about $1,557 more from selling the call legs of the hedges than he would have paid for the puts.

Risk And Potential Return For This Portfolio

As you can see in the portfolio summary above, the potential return of this portfolio over the next six months was 5.67%. That's what the portfolio will return if each of its underlying securities achieves its expected return as calculated by the tool. The limiting factors here are the expected returns; the hedges are built around them, in an attempt to capture them. Had our hypothetical investor entered his own, higher expected returns for each of these securities in the second step above, the potential return he was presented with would likely have been higher, though by how much would depend in part on how much higher the hedging cost ended up being. Note, though, that the maximum drawdown for this portfolio is 9.79%: if every one of the underlying securities in this portfolio went to zero before their hedges expired, the total value of our investor's portfolio would decline by only 9.79% in that worst case scenario.

[i] To be conservative, the net cost of the collar was calculated using the ask price of the puts and the bid price of the calls. In practice, an investor can often buy puts for less than the ask price (i.e., at some price between the bid and ask) and can sell calls for more than the bid price (again, at some price between the bid and ask). So, in practice, an investor would likely have paid less than $128 for this hedge.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.