My Favorite Warren Buffett Inspired Investing Strategy

Warren Buffett is best known for being a value investor who made billions of dollars by transforming a struggling textile manufacturer into an insurance and investments powerhouse. Fortunately for us mere mortals, Buffett has been exceptionally generous in sharing his wisdom with anyone who is willing to listen. If you pay attention to both what he says and what he does, you can create some rather interesting ways to attempt to beat the market.

My favorite Buffett-inspired investing strategy comes from combining three of his strategies:

• Value investing
• The basic concept of how insurance works
• Selling options, a tool Buffett himself has used.

By doing so, it is often possible to earn solid returns while investing little more than the money paid to you in options premiums. In essence, you play the role of Buffett's insurance company: collecting premiums, investing them, and (of course) making the payouts when the options are exercised.

Image source: The Motley Fool.

The core of this Buffett-inspired strategy

Here's how the three parts of this strategy work together:

Value investing: The companies I pick for this strategy all share a key characteristic of being fairly to cheaply valued based on some fundamentals-driven valuation approach. Sometimes I'll use a discounted cash flow model, and sometimes I'll use a low price-to-book ratio combined with an expectation of continued profitability.

The fundamentals/value investing part of the strategy is important because the strategy does have risks. In particular, it exposes the investor to around twice the potential downside risk associated with simply owning the stock itself. As a result, an investor following the strategy must be comfortable with the potential of being required to own the stock. While a value price still provides no guarantee of a positive return, it can provide a good reason to believe a positive return could happen over time.

The basic concept of how insurance works: Insurance works because the insurance company is willing to accept a large but not certain risk in return for a sufficient premium. If you face a $100,000 risk that has a 1% chance of happening in a given year, an insurance company might be willing to write you a policy that covers that risk for a $1,200 annual premium. If a $100,000 loss could devastate you, but a $1,200 premium is bearable, you might be willing to buy that policy.

By writing enough of those policies for different people, the insurance company has a good chance of being able to pay out on those risks from the premiums it collects, leaving potential profit for itself. In a bad year, it is possible that the insurance company could end up paying out more in claims than it collects in premiums, which is why reputable insurance companies keep strong balance sheets.

Still, to the extent that insurance companies can choose the policies that they write, they'll write ones where they believe they have a good shot of covering their payouts. Likewise, when I pick companies for this strategy, I tend to gravitate to ones whose prices have recently fallen sharply.

Why do I pick those particular companies? Well, option pricing is in part driven by a stock's volatility. A sharp decline typically increases the volatility associated with a company's options. That tends to make the options pricier than they would be otherwise, which means selling those options often leads to higher premiums than they would otherwise. When combined with the valuation criteria listed above, it can help tilt the risk versus potential reward in a more-favorable direction.

Selling options: Like most insurance policies, options act as time-limited risk-transfer tools. The buyer of the option pays a premium to the seller, in exchange for the seller assuming the risk. For put options, the risk is that the stock will drop below a certain price by a certain date. For call options, the risk is that the stock will rise above a certain price by a certain date.

By being a net seller of options in this strategy -- selling three contracts for every one contract I buy -- I am accepting the risks of further rapid stock declines. In exchange, I get the premiums and the kicker of some additional potential profit if the stock recovers slowly over time.

So what exactly is the strategy?

Executing the strategy involves selling a short-term (typically around three months) short strangle, combined with a longer term (as far out as the LEAPS options offer) near-the-money synthetic long. If you're keeping track of all the moving parts, that involves selling two put options contracts and one call options contract, while buying one call options contract.

The short strangle pays me the premiums up front -- premiums that I keep if the stock closes between the strike prices by expiration. If the stock drops below the sold put price, then I'm at risk of having the shares put to me; which is why I only execute this strategy if I see value in the stock based on its fundamentals. If the stock rises above the sold call price, well, that's one reason for the synthetic long: to protect me from the risk of a fast stock recovery.

The other key purpose of the synthetic long is to provide an opportunity to participate in some of the stock's growth over time. If the stock recovers slowly enough, as the short strangles expire, I can roll them up and out, collecting new premiums on them every few months, while still holding the synthetic long position.

Of course, the risk is that a synthetic long position involves selling another put option, which is how the strategy exposes me to the potential downside risk of owning shares. This, again, calls for only executing the strategy when there is a reasonable fundamentals-based reason to believe there is value in the company's shares.

A real-world example

The most recent example in which I set up this strategy is with aerospace titan Boeing (BA -1.15%), shortly after the recent China Eastern Airlines crash knocked its shares down a peg. That was yet more bad news for a company that has seen quite a lot of it lately. Still, that accident dropped Boeing's market price to less than 10 times what the company earned in 2018, its most recent year before the 737 MAX crisis knocked the company off its perch.

If you assume that Boeing is legitimately cleaning up the issues that led to that 737 MAX crisis, then it's not hard to project a future where it's earning enough to support that share price. That's where the value analysis comes into play.

The market's worry because of that crash made the volatility pricing on the options attractive enough to take on the risks. That's where thinking like an insurance company that's willing to accept risks that are adequately priced comes in to play.

As for the options themselves, the table below shows the specific contracts and strike prices involved:

Table by author based on data from his brokerage account.

The chart below shows the estimated profit for the position at expiration -- ignoring commissions and assuming the options all expired at the same time for the sake of keeping the math understandable. Key things to note include:

• The position is profitable down to a stock price around $176 per share, which is below the stock price at the time I set it up.
• The double downside risk kicks in if the stock falls below $170 per share.
• Profit is capped if the stock recovers above $200 per share.

Chart by author.

Is the risk vs. reward worth it?

The double-downside risk and capped gain in this strategy make it seem silly to consider on the surface. By looking at it through a Buffett-inspired lens, however, it becomes more of a "Heads: I win. Tails: I get a decent consolation prize" scenario.

If the stock goes up, I end up profiting from the premiums on the short options and a bit of the increase in price thanks to the long call. If the stock goes down, I end up owning shares of a company that looked to be reasonably priced on a valuation basis at the time I set up the deal.

Like any insurance-type deal, though, there's always the risk of a catastrophic failure: In this case, the risk is of Boeing itself going into an irrecoverable tailspin. That's why, as much as I like this Buffett-inspired investing strategy, I limit its use only to cases in which both the valuation and the "insurance premiums" make it appear to be worthwhile. After all, it is an advanced options strategy, and the risks are very real.