Warren Buffett is widely considered to be one of the most successful investors of all time.
He began investing in stocks at age 10, and was a millionaire by his early 30s, when he began buying Berkshire Hathaway stock at $7.60 per share. Today, Berkshire trades at about $400,000 and Buffett has a net worth of $97 billion.
Buffett is well-known for his approach of buying big chunks of blue-chip companies with underestimated prospects and strong management. Then he holds those shares for years, if not decades. The secret of his success, he says, is following two rules:
“Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”
But there are three lesser-known tactics Buffett has used to build his fortune that savvy investors might want to borrow — even if they sometimes run counter to his better-known investing strategies.
1. Selling put options
You’d think that someone like Buffett who seems devoted to blue-chip stocks would steer clear of complicated derivatives, but you’d be wrong.
Throughout his investing career, Buffett has capitalized on the advanced options-trading technique of selling naked put options as a hedging strategy. In fact, in Berkshire Hathaway’s 2007 annual report, the company acknowledged that it had 94 derivative contracts, which over the year generated $7.7 billion in premiums.
This strategy involves selling an option where you promise to buy a stock at a specific strike price below its current value sometime in the future. This immediately gives you money from the sale of the option. If the share price doesn’t fall, you keep the money.
If the price does fall below the strike price, you purchase the stock at a price that’s less than you would have paid at the time you sold the option, with the cash from the option sale further reducing your cost basis. This is a good strategy on a stock that you wouldn't mind owning in the first place. In 1993, Buffett used put options to pocket nearly $7.5 million in income while waiting for the price of Coca-Cola shares to drop.
The option is considered “naked” because you haven’t secured another option to buy the stock, such as shorting shares of that same stock to offset your purchase cost.
But keep in mind that this given the risk involved, this isn’t something a newbie investor should try on their own.
2. Investing in small-cap stocks
When you’re throwing around the kind of cash that’s measured in billions, scooping up shares of promising emerging companies won’t work. Shares of small-cap growth stocks of companies typically worth $300 million to $2 billion would simply move too much if the Oracle of Omaha made a purchase that was big enough to make it worth his while.
“I have to look for elephants,” Buffett once said in discussing his investment options. “It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in.”
Of course, it wasn't always like that. Buffett started out his career primarily investing 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 those so-called “mosquitoes” are attractive is because shares demonstrate the most growth in the early days of a company's operation. But just because those little outfits are off-limits to Buffett today doesn’t mean you can’t go after them.
3. Cutting losses when necessary
Buffett’s “buy and hold” approach doesn’t extend to never admitting that even he sometimes gets it wrong. Once losses set in at a well-managed company, that’s a sign that the economics of that business may have changed in a way that’s going to create losses for a long time to come.
As for Buffett, his big misstep recently was investing in airline companies. Berkshire Hathaway once owned a stake in all four major American airlines: Delta, American Airlines, Southwest and United. While he only added these companies to his roster in 2016, by the end of 2020, he’d dropped them all — at a relatively big loss.
Buffett took responsibility for the failed strategy, but was clear he didn’t see a future in airlines and even went so far as to call the industry a “bottomless pit.”
“We will not fund a company that — where we think that it is going to chew up money in the future,” he said at the time.
