Build your own Dividend Paying Berkshire Hathaway with Options
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Warren Buffett was recently asked during Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) annual shareholders meeting about the ever present issue of a dividend paid by the company. There hasn´t been any news there, investors in Berkshire shouldn´t expect any dividends anytime soon, and Buffett has good reasons for that decision.
Over the long run, Berkshire has generated annual average returns in the 20% zone, which is a remarkable victory versus an index like the S&P 500 which produced returns near 10% annually for the same period. If Buffet where to distribute cash to shareholders, they would have to find a convenient investment in which to deploy those funds, and it seems quite unlikely that they will do better than Berkshire in the long term.
Value investors, and Berkshire shareholders are mainly value investors, have a special love for companies with juicy and growing dividend payments. Buffett himself has made these types of stocks a big proportion of Berkshire´s portfolio. Coca Cola Co (NYSE: KO), one of Berkshire´s biggest and most renowned holdings has a 2.6% dividend yield and has been increasing dividends for 50 consecutive years. Another long term holding of Berkshire, Procter & Gamble (NYSE: PG) is also among the favorites of dividend loving investors with a 3.5% dividend yield and 55 consecutive years of dividend increases.
So, if Buffet has selected many classic dividend stocks as his main holdings, why doesn´t Berkshire pay a dividend? After all, the company has plenty of resources to establish an active dividend policy.
The business however is very different when comparing Berkshire with Coca-Cola or Procter & Gamble. Berkshire is an investment company, so Buffett can use its cash when he discovers an attractive opportunity to put big amounts of capital to work at outstanding rates of return, like the purchase of Burlington Northern for $34 billion in 2009. Considering these circumstances, Berkshire will probably keep receiving big dividends from many of its investments, but the company won’t distribute any of those cash flows to shareholders.
Fortunately for investors, selling shares of the company is not the only way to obtain cash from their investment in Berkshire; the options market provides some very interesting possibilities for those who would like to receive recurrent payments from their investment in Berkshire.
The idea would be as follows: the investor buys some Berkshire stock, and at the same time sells puts on the company, it could be for example a 100 share position and the sale of one put contract (with size of 100 shares), but the quantities could vary according to risk profile and personal preferences.
Put options with a strike price of $75 and expiration date in December 2012 are selling for around 2.70, so the investor who has 100 shares of Berkshire at a price around $80 and sells 1 put contract would be generating a 3.4% income in less than 8 months, it would be like receiving a dividend provided the options expire out of the money.
The main risk for the investor would be the possibility of Berkshire falling below 75 before the expiration date of the options. In that case the put would be executed, and the investor would need to buy 100 more shares of Berkshire at $75. For this reason, it’s very important to pay close attention to position sizing, in order to avoid the possibility of being forced to buy a position which is too big for the portfolio.
On the other hand, Berkshire investors are probably those kinds of people who never regret buying a great company at discounted prices, so being forced to buy more Berkshire as prices come down may not be all that bad. In essence, selling Berkshire puts would be like selling a right to force yourself to enter a transaction you wouldn´t lament at all: buying more shares at lower prices.
Put writing can provide a very attractive risk and reward equation when done with high quality companies. After all, the worst thing that can happen to the investor is being forced to buy strong businesses at lower prices, and that would probably be a desirable outcome for long term value investors.
However, this kind of strategy generally requires the use of margin, so it´s absolutely crucial to make sure that the positions are not too big for the portfolio in case there is a generalized fall in the markets and many of the written put options end up being exercised. I would recommend calculating how many shares of different companies the investor would need to buy in case there is a market crash and the puts are exercised. The outcome of that calculation should leave the investor happy and comfortable with his positions.
Berkshire won´t pay dividends anytime soon, if you are one of those investors who like to generate income from their portfolio while at the same time always willing to add to positions if prices give you an opportunity, selling Berkshire puts is a possibility that may adjust quite well to your needs.
acardenal has no positions in the stocks mentioned above. The Motley Fool owns shares of Berkshire Hathaway and The Coca-Cola Company. Motley Fool newsletter services recommend Berkshire Hathaway, The Coca-Cola Company, and The Procter & Gamble Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.