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I am sure this has been discussed before, but I am interested in a mechanical strategy using brkb.
That is what I have come up with borrowing from Jim’s ideas.

1. Only do in a tax advantaged account
2. Buy brkb <= to 1.25
3. Sell brkb >= 1.5, and replace with lrgf

Lrgf is a multi factor fund that should beat the market.

Is t1 a btr way to do this?
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Huh? 1.25 what?
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Why not just use a fast dual momentum filter to switch between BRK and TLT?
On PortfolioVisulizer
https://www.portfoliovisualizer.com/test-market-timing-model...

CAGR 1985 till Present 16.3%, MaxDD -22.24% Compared to BRK.B 9.4%, MaxDD -45.88%

Of course this is a backtest and one can't expect the future will exactly mimic or even rhyme with the past but there is a good chance you might do a little better than holding BRK in a downturn.

RAM
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As the BRK and MI boards are my two main haunts, you can imagine I've spent some looking at this.
In short, it's hard to come up with many reliable models to predict the price of a single stock.
No surprise.

However, like most things, Berkshire's stock price does better if you buy it when it's cheap.
As Berkshire's value growth is unusually predictable, this works pretty well.
You don't know how long it will take to work, but it works very reliably if you're patient.

My best approach (and my main personal investing approach) goes like this:
Check the most recently published quarterly book per share.
When the P/B ratio drops below 1.35 sell some BRK stock (maybe half your position?) and use the proceeds to buy long dated deep in the money BRK call options.
The longest dated leaps are generally about two years out. The low strikes generally offer roughly 2:1 leverage, maybe 2.5:1.
The payoff from buying cheaply can take some time. Be prepared to roll them once for a total investment horizon of four years.
This roll will cost money, as you'll be buying a bunch more time value, so be prepared for that.
With luck you won't have to roll, but the stock price can be flat for long stretches when multiples compress.

Then, next time the stock trades above 1.55 times known book per share, take the profits on the calls and use all the proceeds to buy plain stock again, ditching the leverage.
So, you're invested all the time, but pile on a little leverage when the outlook is particularly good.
It's much like your switch, but instead of switching between BRK and something else, you're switching between BRK and more BRK.

This approach uses calls rather than broker leverage because the leverage built into calls is uncallable.
If there is a horrible market crash, you can't get a nasty call from your broker. You just ride it out.

Right now the stock is at $309,000 ($206 per B share), giving P/B of 1.351.
It has been that cheap or cheaper about 20% of the time in the 6 years since the buyback program was initiated.
Today's price is also almost spot on that "leverage below 1.35 times book" threshold I suggest above.
At multiples below this, it's a strong buy.

It's not too hard to build a model to predict the likely stock return based on today's P/B value based on the historical observations.
Given today's P/B ratio, history in the last 15-20 years suggests one might expect one year returns in the vicinity of inflation plus 11.8%-15.3%.
Maybe a bit less if the bear deepens.
Those models will probably be wrong, but the idea of each model is that it's a 50/50 chance of being too high or too low.
The stock is somewhat cheaper than usual at the moment, so the near term outlook is a little better than usual.

Jim
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Right now the stock is at $309,000 ($206 per B share), giving P/B of 1.351...
Given today's P/B ratio, history in the last 15-20 years suggests one might expect one year returns in the vicinity of inflation plus 11.8%-15.3%.


FWIW
Since the stock is down today to $302,770 ($201.85 per B), the P/B is down to 1.32.
My various models therefore forecast one year returns of inflation plus [16.2%, 13.1%, 17.0%, and 17.1%].
Knock off a few percent for conservatism or unpleasant surprises, and it's still a good prospective return.
And if 2019 is flat, then 2020 will likely be excellent.

Downside seems limited.
I'm sticking with my brave prediction that Berkshire will trade below $300k (=$200 per B) less than another month total in future.
It might go arbitrarily low in panics, but that situation is unlikely to last all that long.

Jim
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On PortfolioVisulizer: CAGR 1985 till Present 16.3%, MaxDD -22.24% Compared to BRK.B 9.4%, MaxDD -45.88%

Pretty interesting. TLT does not go back to 1985, so your backtest was actually from 2003.

Here's using WHOSX from 2000 to give two peak to peak cycles (which I much prefer to starting at a trough):
https://www.portfoliovisualizer.com/test-market-timing-model...

When the P/B ratio drops below 1.35 sell some BRK stock (maybe half your position?) and use the proceeds to buy long dated deep in the money BRK call options. The longest dated leaps are generally about two years out. The low strikes generally offer roughly 2:1 leverage, maybe 2.5:1

Happen to have a backtest on this system from ~ March 2000 to now?
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When the P/B ratio drops below 1.35 sell some BRK stock (maybe half your position?) and use the proceeds to buy long dated deep in the money BRK call options. The longest dated leaps are generally about two years out. The low strikes generally offer roughly 2:1 leverage, maybe 2.5:1
...
Happen to have a backtest on this system from ~ March 2000 to now?



That will take a bit of time to set up.

But, as a starter, since March 2000,
BRK average 1 year performance starting days with P/B under 1.35 (23% of the time): inflation+16.9% [system recommends a little leverage]
BRK average 1 year performance starting days with P/B 1.35 to 1.55 (43% of the time): inflation+9.6% [system recommends simple long]
BRK average 1 year performance starting days with P/B over 1.55 (34% of the time): inflation+0% [system recommends simple long]

Those figures are consistent with (and, indeed, the reason for) the suggestion of a little leverage when valuation levels are in the first category.

So, possible implications:
* Having different levels of leverage in those three different starting situations seems to make sense.
A multi-stage or continuously variable strategy might also make sense: the better the entry price, the lower the risk and the higher the likely prospective return.
* Given that today's figure falls in the first category, it's probably not such a bad time to buy, if only for a trade.
If you're patient.
* At some point cash might be a better choice. Or a fancy sell rule to try to lock in bubble prices.
Returns have historically dropped below inflation above P/B roughly 1.67.

Rather than using the specific suggested cutoffs, here are the average one returns based on sextiles.
(each bucket representing 1/6 of starting dates since March 2000)
Starting P/B from 0.975 to 1.292: Inflation + 21.6%
Starting P/B from 1.292 to 1.372: Inflation + 11.6%
Starting P/B from 1.372 to 1.442: Inflation + 8.8%
Starting P/B from 1.442 to 1.511: Inflation + 8.5%
Starting P/B from 1.511 to 1.631: Inflation + 6.8%
Starting P/B from 1.631 to 2.032: Inflation -1.7%

So, another possible implication:
* The valuation multiple is perhaps strongly predictive at extremes, but not so much in the middle ground 1.37 to 1.63.
Today's multiple is at about the 20th percentile since March 2000, which could be considered extreme enough to be worth considering.
It's 1.32 as I type.

Jim
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Mungofitch,

I apologize for hijacking this thread into another one. I know you have mentioned few times on buying long dated calls(LEAPS) on in the money to leverage BRK position. I have done that few times in my career. Have you done any work on potential returns if someone owned through LEAPS instead of common over the years?

Here is an example that I'm thinking: Lets say we have $100K to invest, we are comfortable investing into 500 BRK common stock at @ $200. Instead buying 10 calls of 150 strike January 2021 @ $60 for $60000 and keeping $40000 in cash for rolling it over or potential exercise at some point. I wonder if you have done any analysis on a proposition like that given the leverage and risks of not working out within 2 years. Thanks!
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Huh? 1.25 what?

Price/book
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Then, next time the stock trades above 1.55 times known book per share, take the profits on the calls and use all the proceeds to buy plain stock again, ditching the leverage.

If you bought the stock at 1.55 p/b, wouldn't you be buying it at an inflated price?

Thanks.
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Then, next time the stock trades above 1.55 times known book per share, take the profits on the calls and use all the proceeds to buy plain stock again, ditching the leverage.
...
If you bought the stock at 1.55 p/b, wouldn't you be buying it at an inflated price?


Sure.
But you're simultaneously selling those calls you just made a killing on.
So, if you're selling (say) 10 calls representing 1000 shares and buying 400-500 shares with the proceeds, it's a net reduction in exposure of 500-600 shares at that high price, locking in the profits.
It's not a buy signal, on a net basis it's just a "time to end the leverage" signal, which is a partial sell.

Why not just go to cash? Why keep holding as it rises up through fair value into the overvalued territory?
Because sometimes the firm continues to do well. Sometimes book per share rises 15% two years in a row.
If you go to cash at P/B 1.55 then wait for a lower multiple for re-entry, by the time the P/B is cheap
again the book per share value might be 20% higher and so your re-entry price is no better in absolute terms.
This is why it's hard to make a long/cash trading system that's profitable.
It's a nice long term hold, so I'm happy holding the core of the position through thick and thin.

Note, much of this same reasoning can be applied to index funds if you like those.
Hold your core position long through thick and thin as a true Boglehead.
But, on the rare occasions the market is cheap, go in with a bit of leverage till it is fairly valued again.
Imagine selling half your SPY in spring 2009 and using the proceeds to buy deep-in-the-money SPY calls.
When things looked more normally/fully valued, maybe a couple/few years later, sell the calls and use the proceeds to buy back your SPY (and more).

As an aside, I wouldn't call P/B 1.55 "inflated" for Berkshire. "Fair but rare", maybe. Most of the time the stock is somewhat underpriced on average, it seems.
You could wait for overvalued before selling (or dropping leverage), but that's so rare you couldn't build a trading system around it.

Jim
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Have you done any work on potential returns if someone owned through LEAPS instead of common over the years?
Here is an example that I'm thinking: Lets say we have $100K to invest, we are comfortable
investing into 500 BRK common stock at @ $200. Instead buying 10 calls of 150 strike January 2021 @
$60 for $60000 and keeping $40000 in cash for rolling it over or potential exercise at some point.
I wonder if you have done any analysis on a proposition like that given the leverage and risks of not working out within 2 years. Thanks!


Short answer: This is more or less how I make a living.

There are risks.
Leverage is the #1 way for smart people to go broke.
For it to be safe and smart and prudent, you have to hit a lot of checkboxes.
* The underlying asset you select has to be extremely safe and not falling in value.
* The asset has to be far from overpriced when you start a given leveraged hold.
* The leverage has to be cheap. No sense paying 6%/year for leverage to buy an asset rising in price at 5%/year, and probably not even if it's rising at only 8%/year.
* Most importantly, the leverage has to be uncallable. No brokerage leverage ever, as that can be called on no notice at any time for no reason.
* The leverage has to be evergreen: it has to be available to you long enough for your investment thesis to work out.
There is a reason for the saying that the market can remain irrational longer than you can remain solvent.

LEAPS check most of these boxes, but not quite all of them.
They aren't evergreen. When a given two year period ends, you might have to roll because the price hasn't risen yet.
At that time the implied interest rate in the new options might be prohibitively high, or LEAPS may no longer be available for that security.
And of course sometime option premiums (implied interest rates) are too high, but you know that before you buy.

Here's how I got into this.
A while back, Berkshire was *really* cheap for a while in Q3 2011. (And again early 2016, but not the instance I'm thinking about)
I bought a bunch of out-of-the-money call options as what I thought of as high quality lottery tickets,
figuring I'd just sell them at a profit if they go well, and end up back with my original position size plus a one-time cash windfall.
But it worked better than I had hoped. The stock price soared. All of a sudden I ended up with in the money calls with relatively low leverage.
In effect, my equity in the shares they controlled was high enough that they were now more like part of my core holding.
So, I figured...why sell them? Just keep rolling them. To date that has been pretty cheap. So I still have that position, still rolling.
Sometimes when it's time to roll (every other time, say), the stock price has risen so much that
even a much higher strike is now pretty deep in the money, so I roll "up and out". (later date, higher strike).
This frees up a bunch of cash. I use that for living expenses, without reducing the number of shares I "control".
This happy situation will gradually come to an end as the implied interest rates rise and the growth rate of Berkshire's value gradually slows.
But, up till now and for a little while yet, it has been great.

So, with all that as background, your question:
Yes, this works.
PROVIDED the interest rates are good enough, and the security you pick is growing very reliably and meaningfully faster than the implied interest rate.
The degree to which it works is mainly based on how cheap it is when you start, and of course whether it turns out to be as predictable as you thought.
Everything has a bad stretch from time to time, sometimes temporary, sometimes permanent.
When it comes to leverage, it is far better to use an underlying security which is growing at an extremely predictable 7-11% than at a merely very probable 15-20%.
One good defence is to do this with only part of your position.
e.g., in your example, start with a mix if cash, shares, and calls, not just cash and calls.
Lower overall leverage is more prudent. (unless maybe the asset is dirt cheap!)

As for the risks of it not working out within two years, I always figure on 4 years as a best guess.
This isn't really enough all the time, but usually. Sometimes it takes 5 years, so you might need to roll twice. Be prepared.
Examples for Berkshire:
Five years starting 2004-03-09, price went from $94790 (P/B 1.877) to $73195 (P/B 1.038). That was before options were available.
Five years starting 2007-12-11, price went from $148900 (P/B 1.922) to $130788 (P/B 1.171).
But note that such bad things are likely to start at times of high valuations.
The odds are you won't see that sort of thing happening starting at a low valuation multiple.
For the price to be flat that long for a growing firm, it has to start out fairly expensive and end up very cheap, which is what happened in that case in these examples.

That 2007-2012 stretch took some serious gritting of teeth, and the two rolls cost money I had to pull from elsewhere, but it worked well in the end.
The price gains in 2012/2013/2014 were 17%, 33%, and 27%, and I was (moderately) leveraged through all of that.

Jim
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Why not just use a fast dual momentum filter to switch between BRK and
TLT?


1) BRK.b started in 1997, not 1985
2) Your momentum asset (SPY) started 1994, not 1985
3) TLT was benefited by declining interest rates, which is unlikely to happen again.

However....when I changed it to BRK.A for asset & momemtum asset, and OOM
asset to be cash, CAGR was 11.49% & MaxDD was -27%.

But...Equal Weight (cash & BRK.A) CAGR 15.74%.

https://www.portfoliovisualizer.com/test-market-timing-model...

Using VFINX (same as SPY) for the timing asset, CAGR 12.98%, but MaxDD -56%
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How deep in the money? 10%? more?

Fascinating read, Jim, by the way.

Mark
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Jim,

Thanks for a very informative post.

How do you pick strike prices for LEAPS? if I look at Jan 21 expiry, following choices appear reasonable:

Jan 21, $150 for around $64 (time value $14 or 3.5% per year)
Jan 21, $100 for around $108 (time value $8 or 2% per year)

and so on.


Thanks.
Deepinder
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How deep in the money? 10%? more?
...
How do you pick strike prices for LEAPS? if I look at Jan 21 expiry, following choices appear reasonable:


I always go for the longest dated, and, from among those, the cheapest in terms of implied interest rate, deep in the money.
You don't need much leverage at all to turn a "steady as she goes" return of 8-9% into a "you're doing great" return of 14-15%.
The lowest implied interest cost is generally found at the lowest strike available, but not always.
Sometimes the bid/ask on the very lowest strikes is so wide that what you gain in settling for cheaper lower leverage, you lose in execution costs.

Here's the math I use:
Get the bid/ask prices at close for each strike that's in the money.
Estimate the execution price for each one if you're a buyer, generally 75% of the ask + 25% of the bid.
Your breakeven price is the strike plus that option cost.
The amount "extra" you're paying is the amount by which your breakeven exceeds the stock price at the moment.
I simply assume I'm going to hold every option till expiry, so the "extra" cost will all be a dead loss.
The amount of money you did NOT have to put up to buy the same amount of stock today, the difference between the stock cost and the option cost, your is "borrow".
Your effective interest is the "extra" amount divided by the "borrow".
Since it's prepaid rather than compounding I annualize that linearly as rate * 365/(days to expiry).

Doing that for 2021 options at Friday close, you'd get the following:
   Strike      Bid         Ask         Execution   Breakeven   Extra       Borrow      Raw Intr    Annual      Leverage
130 78.70 83.50 82.30 212.30 11.38 118.62 0.0959 4.96% 2.44
135 74.00 78.50 77.38 212.38 11.46 123.55 0.0927 4.79% 2.60
140 71.35 73.55 73.00 213.00 12.08 127.92 0.0944 4.88% 2.75
145 67.50 68.85 68.51 213.51 12.59 132.41 0.0951 4.92% 2.93
150 63.50 64.80 64.48 214.48 13.56 136.45 0.0993 5.14% 3.12
155 59.25 61.10 60.64 215.64 14.72 140.28 0.1049 5.42% 3.31
160 55.65 57.15 56.78 216.78 15.86 144.15 0.1100 5.69% 3.54
165 51.65 52.65 52.40 217.40 16.48 148.52 0.1110 5.74% 3.83
170 47.95 49.50 49.11 219.11 18.19 151.81 0.1198 6.20% 4.09
175 43.35 45.90 45.26 220.26 19.34 155.66 0.1243 6.42% 4.44
180 40.20 41.90 41.48 221.48 20.56 159.45 0.1289 6.66% 4.84


In this case, the cheapest one seems to be the second-lowest strike of $135, at 4.79%.
That's the one I'd go for.
It's interesting to note that this interest rate is over a full percentage point cheaper than it was a couple of months ago because the Fed has, rather foreseeably, blinked.
The implied interest rate can be thought of as the average of the expected short term policy rates in the next couple of years. Plus a small constant.

For executions on these, you can generally rely on paying about 75% of the bid/ask spread.
Frequently you'll manage better, 70% or even 65% sometimes, but you can generally count on 75% for budget purposes.
Set a limit at the midpoint between bid and ask.
If it doesn't fill after 15-30 seconds, and move the limit up 5 cents. Repeat till it fills.

So, how are the prospects of this contract at the moment?
The stock is at $200.92 at the moment, and trading at P/B of 1.317. On the borderline between cheap and very cheap.
Book per share will probably rise 20% in the next two years, give or take.
A fairly normal P/B multiple in this post-crisis world is about 1.4.
So, a not bad guess of the stock price in two years is about $256.30 per B share.
This means the end value of the $135 calls will be $121.30.
You'd pay $74 for those today, so you've had a return of 64%.
Since it's almost exactly two years to expiry, that's about 28% CAGR.

Of course the price might be lower than that in two years, which is why I suggest always thinking of it as a four year investment.
If the price is low after two years you roll the contracts out another two, to get more time for the valuation thesis to work out.
This roll increases your breakeven a lot, but on the other hand you get two more years of probable
growth in book per share, so the "normal" expected ending share price at year four is that much higher.
You probably still do very well, it just takes a little longer.
I find it remarkably easy to do well in the markets as long as you don't really care which years are good ones.

For financial planning purposes, I don't think of this as anything like 38% CAGR.
I think of it as 13% CAGR on the underlying stock I control, plus an uncallable term loan.
That's because there are various ways I can change the leverage on my position, but the position size doesn't change all THAT much over time.
And because counting those amazing CAGR numbers from option leverage frequently leads to poor decisions.

Somebody asked about a backtest.
I did a quick test from Jan 2000 to present, fairly conservative.
When P/B crosses above 1.5, go to no leverage.
When P/B crosses below 1.35, go to 1.5 leverage.
Assume the borrowed portion of the leverage costs an average of 4.5%/year in interest (whether from HELOC or calls, whatever).
That's reasonably generous for this century while 3-month T-bills averaged 1.63%.
This strategy went with leverage 44% of the time, total of 8 signals.
The end result increased the buy-and-hold return of 9.01% by 2.07%/year to get a portfolio return of 11.41%. SPY managed 5.19%.
Same method but using 2:1 leverage when appropriate moved the improvement up to 3.94%/year for an end return of 13.27%.
(BRK was more expensive in Jan 2000 than it is now. Book per share rose 10.11%/year but P/B dropped 12.5%)
This is a quick summary of a test with 1.75 leverage, final CAGR 12.37%
  Period         Period      Stock      Portfolio
start end return return
2000-01-03 2000-02-09 -11% -11%
2000-02-09 2000-04-13 22% 38%
2000-04-13 2008-11-12 75% 75%
2008-11-12 2014-12-02 118% 185%
2014-12-02 2015-08-21 -10% -10%
2015-08-21 2017-02-22 26% 41%
2017-02-22 2018-05-29 12% 12%
2018-05-29 2019-02-07 6% 8%


Jim
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Jim, if I have no BRK-B now and I am going to invest 50% of my money into the long dated Brk-b leaps would you do it at one time or in pieces?
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Jim, if I have no BRK-B now and I am going to invest 50% of my money into the long dated Brk-b leaps would you do it at one time or in pieces?

It's cheap now. I'd definitely just go for it.

My prediction is that the market price will be under $300k ($200 per B) less than 20 more trading days total, ever, in future.
Maybe I'm wrong, but probably not by all that much.
So, with the price at $201 per B now, the downside is pretty limited and the chances of doing materially better are limited.

This is the answer presupposing that you have already decided how much to allocate to it and how much leverage to use.
And that you have used sound and prudent considerations in arriving at that decision.

Remember that you'll have to have a way to come up with cash in two years in case the price is low at that time and you need to roll them out to 2023.
Right now two years of prepaid "interest" is about $11.50 per share, and it could be substantially more than that if the share price is really low and interest rates are high.

But by January 2023 something good should have happened to the stock price.
My longer term predictive model is a three year CAGR of 12.3%/year from here. A bit less if there's a recession.
That works out to a target average price of $426,549 or $284 per B share in the period 2-4 years from now, which is the same as a target for February 2022.
Three years ago this model predicted this past week's price would be $307,615. The actual one week average is $307,500 right now.
It's a pretty good model, but not usually quite *that* good : )

Jim
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Since, I am not that comfortable with options, would going to spy or rsp at a p/b above 1.5, and staying in brkb if it is below 1.5 be a viable model?
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Since, I am not that comfortable with options, would going to spy or rsp at a p/b above 1.5, and staying in brkb if it is below 1.5 be a viable model?

I don't think that sounds good.
There are times that one is overvalued and the other is even more overvalued, or vice versa, or one of each, neither or both.
Just because BRK is getting fairly-to-fully valued doesn't mean RSP is a better deal at that time.
An example would be January 2018, when (on my estimation) BRK was fully valued by RSP was a substantially worse idea.
If you're not comfortable with options, I don't think this strategy would be a suitable replacement for the strategy suggested.
I frequently recommend a portfolio of half BRK and half RSP to my "not interested in investing" friends.
Forget about valuation, don't rebalance. Spend the dividends, smell the roses.

If you want a bit of an edge, occasional options are in fact pretty good and not that scary.
You can't lose more than you spend on 'em, and they're generally allowed even in retirement accounts depending on your country.
On those rare occasions that either security is manifestly dirt cheap, buy a few calls with low risk.
A coupla percent of your portfolio in out-of-the-money call options which can go to zero, or several percent in the money ones which basically can't.
But not at-the-money options. They're always overpriced.
But if you don't like options and don't like getting fancy (an excellent stance), just don't get fancy at all.

Jim
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I don't think that sounds good.
There are times that one is overvalued and the other is even more overvalued, or vice versa, or one of each, neither or both.
Just because BRK is getting fairly-to-fully valued doesn't mean RSP is a better deal at that time.
An example would be January 2018, when (on my estimation) BRK was fully valued by RSP was a substantially worse idea.
If you're not comfortable with options, I don't think this strategy would be a suitable replacement for the strategy suggested.
I frequently recommend a portfolio of half BRK and half RSP to my "not interested in investing" friends.
Forget about valuation, don't rebalance. Spend the dividends, smell the roses.

If you want a bit of an edge, occasional options are in fact pretty good and not that scary.
You can't lose more than you spend on 'em, and they're generally allowed even in retirement accounts depending on your country.
On those rare occasions that either security is manifestly dirt cheap, buy a few calls with low risk.
A coupla percent of your portfolio in out-of-the-money call options which can go to zero, or several percent in the money ones which basically can't.
But not at-the-money options. They're always overpriced.
But if you don't like options and don't like getting fancy (an excellent stance), just don't get fancy at all.
Thanks. That is a perfect answer. While I love investing, options always seemed a little too complicated for me.

Jim
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While I love investing, options always seemed a little too complicated for me.

Most smalltime options traders (i.e., us) are looking either for a lottery ticket or something that returns a regular but small income most of the time. Don't play either of those and you'll most likely avoid the risks that they don't see.

I think that most of the "complicated" is the attempts to avoid the risks.

The thing that Jim's been talking about it neither of these, and it won't be attractive to the people who like them. It's boring and the payoff doesn't happen for a couple of years (or more). It's actually pretty easy to understand, once you get what he describes---a way to achieve non-callable leverage.

Not many people playing that game, so the counter-party (which is invariably a computer) will take any reasonable deal you offer. I almost always get an immediate fill when I offer something near the midpoint of the spread. You are almost always the only person wanting to buy that option, so it's either sell it to you or not sell it at all. And then you sit on it for a year or two.

If you don't sell options, the only money you have at risk is what you paid. If you sell an option, you get the immediate gratification of receiving money, but are exposing yourself to a potentially very large risk.
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Maybe I will try it, if the market or brkb ever goes down a lot.
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Thanks for this analysis. Does the Open Interest or the Volume traded make much difference on the fill?
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I actually did this today. The 130’s looked cheaper using your method, sold some stock and bought the calls.
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I actually did this today. The 130’s looked cheaper using your method, sold some stock and bought the calls.

Hmmm. We often wonder about the herd effect killing the performance of our screens.
Or, the post-discovery effect doing the same.
Somehow, I'm thinking this strategy is immune to those problems, which would be a beautiful thing if true.


Mark
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I actually did this today. The 130’s looked cheaper using your method, sold some stock and bought the calls.

I hope it works well!

When it comes time to roll them (if you do), roll them at the earliest date that you can roll out another two years that is fairly calm and the price is fairly high.
The January 2023 options will presumably start trading some time in mid-to-late 2021. (they changed the start-of-trading rule twice in recent years).

The early date means you recoup a little of the time value you prepaid at the beginning before it evaporates to zero.
Time value disappears very rapidly as expiry date approaches, so this reduces your average annual cost for the "loan" you're getting from the leverage.
The reason for the calm day is that during your roll you will be net buyer of time value, and time value is cheaper on calm days.
The reason for the high price day is that options are cheaper the further they are below the current stock price.
So, for any given strike, that options at that strike will be a lot cheaper if the stock price has really pulled away from it.
You either get a better deal on the strike you were looking at, or get higher leverage at a higher strike for the same price, i.e. the same implied interest rate.

FWIW, my latest price forecasts for Berkshire: https://boards.fool.com/it39s-a-tricky-questionfirst-we-have...
Don't take them too seriously, but I figure even a really dirty windshield is much better than flying blind.
The last number is $415 per B share in six years, assuming 2.25% inflation, representing inflation+10.4%/year from the $200.93 price per B share when I wrote the post.
A recession might postpone all those price forecasts by a year, but not really affect the investment case that much.

Jim
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Thanks for this analysis. Does the Open Interest or the Volume traded make much difference on the fill?

Nope.
There are no "real" traders as counterparties, you're essentially always just dealing with the market maker.
So when you buy, you're almost always increasing the open interest yourself, creating a new contract.
The reason for using the moving limit to trade it is just to see where he/she/it will trade, which I assume is some predefined formula.

On rare occasion you'll see anomalies, of course.
I find you can do a whisker better in the last minute of the trading day, even the last 15 seconds.
Maybe they figure "oh well, I can book another tiny profit today for no risk".

Like most options they're a little cheaper on calm days.

Jim
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I actually did this today. The 130’s looked cheaper using your method, sold some stock and bought the calls.

You're not the one who bought the 48 options are you? 'cause if that was all you, WOW!!!

FWIW, right now I get the 100 Jan'21 call as the cheapest, at 3.53% pseudo-interest
cost. 1.xX leverage, 51.4% ITM
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When the P/B ratio [of BRK.B] drops below 1.35 ... buy long dated deep in the money BRK call options.
...
[When] the stock trades above 1.55 times known book per share, [sell] the calls and use all the proceeds to buy plain stock again, ditching the leverage.
You're switching between BRK and more BRK. [That is, between flat and ~2X leverage.]
...

If the price is low after two years you roll the contracts out another two years.


Why?

Why automatically roll? Why wouldn't you look at the P/B ratio at the time and use that to decide whether or not to buy new calls?

The way I look at it, there is no such thing as "roll". What there is, is you sell the old position (at a loss), put the proceeds to cash and then buy a new position.

You aren't buying a 4-year call---you can't. You can only buy a 2 year call, even though you'd like to buy 4 years. But the only thing you can do is buy a 2-yr call, and then 2 years later buy another 2-yr call. That new call will be priced according to the conditions (underlying price and P/B) at that time, *not* according to the conditions of the first call.

Suppose the P/B goes like this:
t+0 -- 1.35, therefore buy DITM call.
t+2 -- 1.45. It never got to 1.55, so you never got to the sell point. But the option expires so you have to sell it and get the cash.

If you roll, then you are buying at P/B of 1.45.
Why?

Even though is is t+2 for Jim, it's t+0 for Berkfan. But the current P/B is 1.45 for both Jim and Berkfan, and the price of the call is the same for both Jim and Berkfan. Why should Jim buy a call but Berkfan should not?

The logical outcome of the conditions you've stated is that you should buy a call (that is, use leverage) whenever the P/B is below 1.55, as long as the P/B was below 1.35 anytime in the prior 2-3 years.

I'm confused by this.
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I bought 2 @ 83
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The way I look at it, there is no such thing as "roll". What there is, is you sell the old position (at a loss), put the proceeds to cash and then buy a new position.
You aren't buying a 4-year call---you can't.
...
If you roll, then you are buying at P/B of 1.45.
Why?


On the question of whether the rolled contract is really a separate position---
You can look at it whichever way you like. Various outlooks are valid and useful in their own ways. I guess the tax man thinks as you do.
Personally, I view it in the way that most closely matches my investment case, not how the investment is implemented.
I see it as a four year wager that might or might not work out well sooner.
The notion is that the market price is probably going to be fair bit higher some time in the next four years, as multiples are very likely to expand and real book per share is also very likely to rise.
One or the other will probably reward me, preferably both.
If the investment thesis happens to take less than two years to work out well, there is just this bookkeeping thing you have to do at around the two year mark called a "roll".
From the point of view of my investment analysis, it's still the same position before or after the roll.

But to answer your question narrowly, why are you still a buyer at 1.45 at the roll date in your example,
it's because you haven't made all of your target and probable profit yet.
You're nicely profitable already, but the odds are decent you'll see an even better exit point some time in the second two-year stretch.
A guy just starting to follow my rule would not, as you note, be buying the calls at 1.45.
He'd be staying long but not adding leverage at that date, whereas you would be buying calls and having (keeping) leverage.
But he is not in the same situation as you.
He doesn't already have a profit to date banked part way through the up-to-four-year investment round, so his margin of safety is not as large.
Sure, he too would probably see a higher exit price in that next two years if he bought, just as you will.
But, start-to-finish, his position has less upside and more downside than your start-to-finish position, so leverage isn't recommended.
Your likely worst case end-to-end is probably near breakeven, but his might be a loss because of the higher entry multiple.
That's why the rule doesn't recommend he use leverage at that date, even though it recommend that you continue yours.
It's geared for very low downside on the entire start-to-finish positions it recommends.
A start-to-finish investment round would include take the entire up-to-four-year holding into account.

Note, what I do myself isn't exactly akin to the strategy I suggested.
I have a big BRK position all the time. It just changes size from time to time.
Though I have had strong opinions and observations on the risk/reward at different P/B cutoffs for
quite a few years, I just made up this specific rule with these cutoffs when writing one post in this thread.

Ultimately the strength of the system comes from the underlying theory that multiple expansion is pretty likely.
How likely is multiple expansion in the target time frame? It depends how much expansion you're counting on how soon.
Since '96 there hasn't been a rolling four year period the stock didn't close over 1.479 times known book.
For starting dates with at least a 10% discount to my own valuation yardstick, as now, the worst observed three year historical forward stock return was inflation+5.6%.
(that assumes you closed your position by spreading the close process over a period before and after the three year mark and looking at the average IRR of those minicloses)
The future may differ, for better or worse.
The four year time horizon is not a worst case. There have been times you'd need to roll the contracts twice
to ensure a good profit (in the 5-6 year range), but those long stretches didn't happen starting from valuation multiples this low.


I agree it's entirely sensible to size your position based on the relative attractiveness of the current price.
Add to the position when the valuation multiple is low, and hold less when it's more fully valued.
(This makes sense for any investment, unless you have a particularly unpleasant tax situation.
The lower the valuation, the higher the reward and the lower the risk, so the larger the portfolio allocation makes sense).
The specific numbers you choose for "but more" and "sell some" cutoffs don't matter too much.
Maybe you'd drop your leverage and go to simple stock at P/B of 1.65, or maybe at 1.45.
The basic idea is that it makes sense to go in hard when the price is unusually attractive.
You could simply stay in that hard, or take a quick buck.
I guess that choice depends on how much you stretched to go in "hard" (did you draw down your HELOC or just allocate cash on hand),
how safe you feel with that burden, and what other good opportunities are available.

As an aside, you could also do the allocation based on valuation as an almost continuous function of valuation level and get much the same result.
I used to trade around my position more than once per day on that theory, with a formula based on P/B setting my target share count.
You make very much less per trade with small cutoff increments, but you trade a whole lot more.
It worked, but gosh it's time consuming.
Perhaps there's perhaps a happy medium of maybe four or five different allocation sizes, matched to tiers of P/B.

Jim
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If you roll, then you are buying at P/B of 1.45.
Why?



I may or may not have in that situation. If it happened to be 1.45x of the to be posted bv for year end 2018 ($143.50 maybe...) then yes I would likely roll.

I'll give you a real world example from one of my accounts over the last 4 years. Hopefully it's helpful.

I did not own any BRK.b in this account prior to this trade.

01/16/2014: Buy Jan16 80s for $39.60 P/B 1.36x
12/14/2015: Sell Jan16 80s for $51.65 P/B 1.31x

Seemed like a good time to roll
12/14/2015: Buy Jan18 90s for $49.00 P/B 1.31x
12/01/2017: Sell Jan18 90s for $104.72 P/B 1.56x

It didn't seem like a great time to roll so I bought shares instead on 12/01/207 for $193.67.

05/03/2018: Sold some shares for $190.13.
05/03/2108: Buy Jan20 120s for $79.25 P/B 1.36x (half my original leap position)

I bought too early once again but it was the first quarterly drop in book since 2011 and I believed it was temporary.

10/26/2018: Buy Jan21 130s for $82.00 P/B 1.37x (other half of my original leap position)

Maybe I bought too early again but at 1.3x Q4 peak book it should work out ok. After looking at the pattern of buying too early there's probably a lesson in there that I need to quit looking at my estimate of the next quarter book value. But the overall return has still been very nice.

So now I have my original leap position on again and spread out over expiration dates 12 months apart, which is something I've been wanting to do since the start. And I have shares I can sell if I need to raise funds for any of the rolls.
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In regards to rolling the calls when the price is high to get the calls cheaper, I'm a little confused as to why that would matter all that much since you are also then selling your existing calls for 'cheaper' as well? Isn't it a wash assuming it's all done the same day?

Thanks,
Jeff
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In regards to rolling the calls when the price is high to get the calls cheaper, I'm a little
confused as to why that would matter all that much since you are also then selling your existing
calls for 'cheaper' as well? Isn't it a wash assuming it's all done the same day?


No, it's not really a wash.
In terms of the underlying stock price, yes, it's a wash.

But you're also an "investor" in a lot of time value in the options.
You're selling options that have little or no time value left, and buying new ones that have lots of time value to cover the cost of the next two years of leverage.
So, you are a big net buyer of option premium on that day.
You want to get the most benefit from that purchase, at the lowest cost.

There are several things that affect the amount of time premium you'll have to buy.

You want to roll at the earliest convenient date, trying to meet the other goals below, as the
time premium on the ones you're selling will be evaporating faster than the time premium on the ones you're buying.
By rolling two or three months sooner you might recoup $1 more time premium on the old ones but
only spend only another $0.20 cost on the new ones because they have longer to run.

Option premiums are high on panicky days, so you want to roll on a calm day. Low VIX. Those tend to be days that the market is flat or rising.

But more important is the goal of trading on a day that that stock price is high, to the extent that you get a choice.
If you want to buy options of a given strike price, say $160, those will be much cheaper on
a day that the stock is trading at $225 than they will on a day that the stock is trading at $195.
If you look at the curve of option premium cost, it's always highest for the strike prices nearest the stock price.
With a bigger gap from strike to stock price, the same options will be much cheaper.
Usually you think of this effect when you're choosing what strike to buy at today's stock price, but the reverse is true too:
at any given fixed strike price, the time premium built into the option fades as the stock price pulls further away from the strike.

You can also look at is as affecting your trade-off. We're being greedy here, so in one sense we
want to find the option with the highest strike price and lowest implied interest cost.
When the stock is high, this trade-off is much better.
You can get a much higher strike price (higher leverage) for the same implied interest rate,
or you can get the same target leverage for a lower implied interest rate.
You get to choose how much of each of those extra benefits to take.

This has an implication for buying on dips. It's expensive to buy call options on dips.
The price is low, and the market is panicky. Really inconvenient.
A surprising amount of what you're gaining by buying when the stock price is low is surrendered because the higher time premium raises your breakeven/entry price.
So, sometimes what I do is buy plain stock when there is a sharp price dip (no time premium!), eating way into my cash cushion...for a while.
But sure enough, panics end, so within a few weeks or months the stock price will be higher and the market will be calmer and I sell the stock to buy the calls I would have bought on the dip.
By this time their time value is vastly cheaper...calmer day, higher stock price.
Of course this is only suited to periods when the stock price is so low that it's almost certainly a very temporary situation.
Berkshire met that requirement in December, in my opinion. At close Christmas eve P/B was 1.231, the lowest multiple since the dip in December 2012.
Typical one year return starting from that kind of multiple has historically been about inflation+17%. Statistically, it seemed like a good time to top up my position.
I still have those shares....I'll likely switch them to calls some time this year when I anticipate the stock price will be higher.
Or I might just close the position, restore my cash cushion, and spend the profits : )

Here's another aspect of rolling.
Instead of using LEAPS as a one time trade, you can think of it as an ongoing *way* to hold a continuous Berkshire position.
If your strike price is a bit higher with each roll, you can take your profits off the table on
a periodic basis without even reducing the size of your position if, each time you roll, you
are able to choose a somewhat higher strike price.
Sometimes when it's time to roll the stock price will not be higher so you can't roll "up", only "out".
So, maybe you can only roll up to a higher strike price for a reasonable cost every second roll.
That's one reason it's nice to have half your options expiring on even numbered years and the other half on odd numbered years.

The usual disclaimers.
Leverage is generally a bad idea. It works both ways.
So, if you're going to dabble in the dark side, do it in the safest possible way you can.
Keep the leverage modest, do it only if the cost is low, the "loan" has to be uncallable even during the worst market panics,
and it should be secured over the longest available time horizon to give time for things to work out.
And of course the underlying security should be the absolutely safest and most predictable thing you can find.

Jim
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I'll give you a real world example from one of my accounts over the last 4 years. Hopefully it's helpful...

Thanks for posting this summary.
Outstanding executions and decisions, I'd say.


As for buying too early...that's usually a sign of a sensible value investor.
You want to have a really good idea of what price level is a really good deal, and buy then. Ignore it if it drops lower than that for a while.
You never know how much further the price will drop, so waiting for some magical lower bottom means you often miss the deal you spent so long to figure out.

Jim
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Now here's an interesting thing. Riffing off JIm's comment on the 9th (post #273383) [when I was busy all day with the grandbaby twin's 5th birthday party].....

In that post he said the pseudo-interest rate on the Jan'21 130 call was 4.96%. Since I *always* re-check things like this--because I am deathly afraid that my spreadsheet calculations are wrong-- I plugged in his numbers into my spreadsheet and sure enough----got pretty much the same rate.

But I also plugged in the numbers (actual options montage from Etrade) on the 12'th [back home]. You have to grab the quotes during the day when the market is open, otherwise the quotes tend to be nonsense.

BRK.B was 205.96 -- up from Friday. The pseudo-interest rate on the Jan'21 was 3.91%. Almost a whole percentage point less.

The lowest strike Jim posted was 130, but when I looked on the 12'th the lowest strike was 100. Not sure if Jim just didn't include it or if they added more strikes. Open interest on the 100 is 630.

Aaaaah, they added more strikes at some point. On 1/15/19 the lowest strike was 120.
Interesting.....then, the 130 had a PI rate of 4.45% and BRK.B was 196.47.

Not sure what all this means. Maybe the takeaway is to just keep watching the PI rate and time your buy for when/if this rate drops. Now, all we need is the ability to foretell when this will happen. Easy peasy, if you already have the ability to foretell when in the next couple of weeks the stock price will be temporarily high.

So, okay, probably now that we all know about this strategy, it will stop working just like YieldEarnYear did.
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I actually did this today. The 130’s looked cheaper using your method, sold some stock and bought the calls.

Looks like you're off to a flying start...midpoint up maybe $4 in a couple of days?
It's nice when that happens.

Jim
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BRK.B was 205.96 -- up from Friday. The pseudo-interest rate on the Jan'21 was 3.91%. Almost a whole percentage point less.

Another thing to watch is the plausibility of the bid and ask.
If the bid is oddly high compared to the strikes above and below, or the bid/ask gap unusually narrow compared to other strikes, the "where you can trade" rule breaks down.
That's because, on the rarest of occasions, there is an actual person trying to buy or sell.
At those moments the midpoint of bid and ask is not a good guide to the likely execution price.
What you really want is the midpoint of the market maker's bid and ask, to the extent that you can estimate that.

I download my IB quote page with all the bid/ask numbers to Excel and graph the bid and ask before I trade.
If there's a kink in the graph, but on just either bid or ask but not both, it's probably somebody in the process of trying a limit order.
Not always "fake", of course...I have sold to such people on rare occasion.

As for the $100 strike, yes, I saw that, but I thought it might be an anomaly of some sort.
On that day there was nothing for the strikes *between* 100 and 130.
So I didn't include it in my example.

Right now I'm seeing the lowest estimated interest rate at strike $120 (3.98%), but the bid/ask at that strike is lower than the surrounding ones so it may be a head fake as suggested above.
At the time I did my snapshot there are only 11 contracts offered at the ask, far less than the 100+ at several surrounding strikes.

Jim
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If [...], it's probably somebody in the process of trying a limit order.

You mean like this?
BERKSHIRE HATHAWAY INC DEL CL B NEW JAN-21 $120.00 CALL
Bid/size: 92.00 x102
Ask/size: 96.80 x1

vs.
BERKSHIRE HATHAWAY INC DEL CL B NEW JAN-21 $125.00 CALL
Bid/size: 88.00 x20
Ask/size: 92.50 x186


All the other strike I looked generally had 2-digit sizes. Never thought about checking the size to see if somebody else was trying to buy inside the market maker.

The Etrade quote montages don't show the sizes, just the quotes. But I did make a column in my spreadsheet to show the % difference from the next lower strike, for bid & ask. When I looked yesterday the bid diffs for increasing strikes went like:
-5.1%
-5.4%
-5.6%
-5.3%
-4.4% <<<<<<<<< Anomaly in the sequence.
-6.7%
-6.0%
-7.3%

I don't know if that anomaly means anything or not. But I also (now!) have a little chart that graphs the bids & asks for all the ITM strikes, so a quick glance will show if there's a kink.

Creating a spreadsheet that you can paste the quote montage into makes it so much easier.
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Thanks for posting this summary.

And thank you for continuing to share your ideas and knowledge. I just figured after lurking around here for 20 years it was time to contribute something to the discussion. :)
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I bought the 2021 130's.
If I have to roll in 2 years, do I buy the 130's again, or other depending on prices.
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I thought about my question. Am i right that you roll same amount of original money to whatever is best available leap at the time of rolling, by adding to your original dollars?
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If I have to roll in 2 years, do I buy the 130's again, or other depending on prices.

Let's hope the share price has moved up enough that the 130's aren't even a strike offered in two years. I'm hoping 150s are the lowest strike on offer by Jan21.


Am i right that you roll same amount of original money to whatever is best available leap at the time of rolling, by adding to your original dollars?

Jim can give a much better description than I can, but for me, it depends. I have a rough idea of how much overall BRK I want to hold across my entire portfolio in terms of total dollars invested ($ of shares plus $ of leap premiums). I also have a maximum dollar target for how much I want to have exposed to leap premiums and, as I mentioned above, I would ideally have those leaps spread across various expiration dates.

If you look at my previous example, that particular account happens to be a retirement account and I can no longer contribute additional funds to it. I chose to keep some of my proceeds in shares when I purchased my next leaps so I have additional reserves to cover roll costs should the underlying price drop. That's not a requirement for the strategy because you could move to a higher leverage strike when you roll, but I preferred the lower risk. There's some value in being able to sleep at night.

If I had that same transaction in my regular taxable account I may have increased my number of leaps and and my overall leverage depending on my total BRK exposure because I should be adding additional cash there over the next two years. Or tapping the HELOC if we see extremely low multiples :)
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I thought about my question. Am i right that you roll same amount of original money to whatever is best available leap at the time of rolling, by adding to your original dollars?

Up to you.

Here's what I do in real life: decide how many shares you want to control, relative to your portfolio size, based on the price/value ratio and outlook for returns.
When it's cheap, figure on a large portfolio allocation, and less when it's less cheap.
Once that is decided, figure out *how* you want to have control of that number of shares: shares, long call options, single stock futures, CFD, short puts, etc.

But, to be more consistent with the system I suggested (go to leverage when cheap, stop leverage when fairly valued):
Wait for the first day (not just a roll date) that the valuation is above 1.55 times book.
At that time, close your options and put the cash proceeds back into shares, however many shares that works out to. Sit on those till next time it's cheap.

If P/B has not yet risen above 1.55, and it's time to roll out to a later expiry date, keep the same number of option contracts.
The general rule is to choose the strike with the lowest implied interest rate.
But sometimes several strikes have very similar implied rates.
Choose the highest strike that has a cheap(ish) interest rate...that ties up the least cash for you.
(I tend to look at a scatter plot of the implied interest rate versus the leverage, for each strike).
If that "cheap enough" strike is fair bit higher than the strike on your current contracts, that's a nice bonus, as you free up some cash as you roll.
If it isn't, then you may have to add some cash to the position.

Jim
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If I have to roll in 2 years, do I buy the 130's again, or other depending on prices.
Am i right that you roll same amount of original money to whatever is best available leap at the time of rolling, by adding to your original dollars?


The roll is a new investment. This business of "rolling" is just a variation of the sunk cost fallacy--you are making a decision TODAY based on data that happened in the PAST. That doesn't make sense to me. When you make a new investment, make it based on the current state of things, not on the state of things as they were 2 years ago.

And, as was noted, the 130 strike may not even be available in 2 years.

Nonetheless, I believe that Jim mentioned that you may need to add additional money when you roll. This kinda emphasizes that it is a new investment, partially funded by the money you got when the old investment terminated.
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"I thought about my question. Am i right that you roll same amount of original money to whatever is best available leap at the time of rolling, by adding to your original dollars?"

Up to you.

Here's what I do in real life: decide how many shares you want to control, relative to your portfolio size, based on the price/value ratio and outlook for returns.
When it's cheap, figure on a large portfolio allocation, and less when it's less cheap.
Once that is decided, figure out *how* you want to have control of that number of shares: shares, long call options, single stock futures, CFD, short puts, etc.


Note that Jim has said (or implied) that he has (and keeps) a very large position in BRK. Perhaps even the majority of his account. As such, some of the details of tactics that he has mentioned may not be especially suitable for folks who just dabble with a little bit of BRK. So take what he has said and see how it applies to your own allocation to BRK.

For me, BRK is a sometime investment. Sometimes I own it, sometimes I don't. Jim owns it _all_ the time.
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The roll is a new investment. This business of "rolling" is just a variation of the sunk cost fallacy--you are making a decision TODAY based on data that happened in the PAST.

If you own a stock and look to see how it's doing, and don't sell that day, then the next day is
a whole new investment and the sunk cost fallacy argument applies equally...i.e., not so much.

You could certainly look at the second contract as a separate investment if you like, but it provides no extra information and obscures useful information.
The risk reward profile of the second contract is wildly different on a per investment basis
depending on whether you were or were not in the first half of the investment.

It's one *investment*, just two typing events.

Jim
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This has all been very interesting. There are two questions I have:

(1) Where do you locate the "book value" for BRK? Some quick noodling seems to give me varying numbers.

(2) What about an alternate strategy of selling cash secured puts on BRK. This is essentially another way of purchasing the stock, or holding it. In theory it has the same return slope as the long calls, but has the benefit of giving you better entry during market volatility.

--Gabriel
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If you own a stock and look to see how it's doing, and don't sell that day, then the next day is a whole new investment and the sunk cost fallacy argument applies equally...i.e., not so much.

Well, no. It's making the decision not to sell based on the current condition.

But you bring up a related point that I sometimes bandy about. From something I had clipped and put in my quotes file:
"With high liquidity and low trading costs, there is neglible difference between _buying_ a stock and _holding_ the stock. Therefore, the decision to hold it is equivalent to the decision to buy it."

Oh well. I know that I have a different view on things than other people on some popular investment strategies. Dividend (Growth) Investing, Covered Calls, Rolling of Options....



You could certainly look at the second contract as a separate investment if you like,

A roll involves closing (selling) a current holding and opening (buying) a new different holding doesn't it? Sounds like a distinct seperate investment (in a closely related security).

I will note, however, that when I go to an option I hold at Etrade and click the down arrow it lets me select between "Add", "Close", and "Roll". Aaaaah...but when I click "Roll" it just takes me to the order page where the options are SELL/OPEN and SELL/CLOSE. I can't find a "roll" order type. It appears that there are 2 commissions, not just one.

Okay, how about putting "roll" in the seach box? Takes me to this:
Q: What is meant by "rolling an option"?
A: In the options market, "rolling" is a trading event where the options trader simultaneously closes out one option position and establishes a new, similar option position, usually with a different expiration (a.k.a. "rolling out"), strike price (a.k.a. "rolling up") or both. Options traders can: "roll up" or "roll down" in strike price, or "roll out" or "roll in" to different expiration months.


Etrade, the IRS, and me call it a new seperate investment.

==================
Sorry, this is just me being pedantic. Again.

The basic strategy (DITM calls) I do consider useful and valuable. It's just that calling a roll to be teh same investment is what I choke at.
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(1) Where do you locate the "book value" for BRK? Some quick noodling seems to give me varying numbers.

(2) What about an alternate strategy of selling cash secured puts on BRK.


1) I just use the PriceBook field at portfolio123. It currently shows 1.35, which is the same ad Jim said. I believe it would be from the quarterly report.

Try this: https://ycharts.com/companies/BRK.A/price_to_book_value

2) "cash secured put" is the same thing as a covered call. That's a completely different strategy than using DITM calls as leverage.
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and, from among those, the cheapest in terms of implied interest rate, deep in the money

Some would use implied volatility to find relative cheapness. In what way do you find your conclusion differs using your implied interest rate method? Don’t get me wrong, I actually find your math very satisfying, but just wondering since implied volatility was published on many sites last I checked.

Along the same lines, since you are doing your own math, do you have an API hook to bring live option prices into Excel or a Google sheet to do this math, or are you just doing a simple download?

Somebody asked about a backtest. I did a quick test from Jan 2000 to present, fairly conservative.

That was me; thank you for that detail. Very interesting to see that I guess you are juicing your returns maybe 1.23-1.44x for your effort of adding leverage.

Same method but using 2:1 leverage when appropriate moved the improvement up to 3.94%/year for an end return of 13.27%.

When is 2:1 leverage appropriate?
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If you want to buy options of a given strike price, say $160, those will be much cheaper on
a day that the stock is trading at $225 than they will on a day that the stock is trading at $195.


Say what???

When you buy a 160 strike on a day that the stock is trading at 225, you'll be paying $65 for its intrinsic value, as opposed to $35 on the day it's trading at 195. How is 65 cheaper than 35?? Yes, you might be paying a buck more for the time value on top of that 35. But if I had a wad of cash, looking to buy some BRKB options, I'd do much better when the stock is at 195 than when it's at 225, no matter what the volatility and time value.

Elan
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Along the same lines, since you are doing your own math, do you have an API hook to bring live option prices into Excel or a Google sheet to do this math, or are you just doing a simple download?

I pull up the options montage (calls only) at Etrade and copy/paste it into my Excel spreadsheet. Then I manually enter the current price. Takes me about 10 seconds total.




When is 2:1 leverage appropriate?

Actually, lots of times. There's loads of financial strategy papers out there that discuss (mostly in passing) leverages of 2X, 3X and higher.

Leverage with buying call options is much less risky than typical stock margin, because the most you can lose is what you invested. The broker won't come running after you demanding that you send him a boatload of money.
Also, you can't get a margin call and the broker cannot unilaterally terminate your position.
Being deep ITM, it is very unlikely that you'll lose all your money. If you buy the 120 call when BRK.B is at 205, you have plenty of headroom before you get wiped out.
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When you buy a 160 strike on a day that the stock is trading at 225, you'll be paying $65 for its intrinsic value, as opposed to $35 on the day it's trading at 195. How is 65 cheaper than 35?? Yes, you might be paying a buck more for the time value on top of that 35. But if I had a wad of cash, looking to buy some BRKB options, I'd do much better when the stock is at 195 than when it's at 225, no matter what the volatility and time value.

That's profound, since the entire strategy is mean-reversion. The premium you pay for volatility away from that mean is the very volatility you want and presumably would be willing to pay something to get.

That said, is it fair to say you would prefer a calm day just after a big move where the VIX has just pulled back, but the price of your option price is still where you want it (less in the money)? Or is that just semantics and future telling that never works?

When is 2:1 leverage appropriate?

Clarification: When is 2:1 leverage appropriate within the rules of Jim's strategy?
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If you want to buy options of a given strike price, say $160, those will be much cheaper on
a day that the stock is trading at $225 than they will on a day that the stock is trading at $195.
...
Say what???
When you buy a 160 strike on a day that the stock is trading at 225, you'll be paying $65 for its
intrinsic value, as opposed to $35 on the day it's trading at 195. How is 65 cheaper than 35??
Yes, you might be paying a buck more for the time value on top of that 35. But if I had a wad of
cash, looking to buy some BRKB options, I'd do much better when the stock is at 195 than when it's
at 225, no matter what the volatility and time value.



You've taken a sentence out of context and therefore lost the meaning.

That post is entirely a discussion about a roll transaction. The first few words are "In regards to rolling the calls..."
Buys, sells, and rolls of options are three entirely different kinds of trade. This is an excellent demonstration of why they are different.

Sure you want to be a net buyer of call options on days that the stock price is low.
But the post is entirely about rolling options, not buying options.
You want do to rolls on days that the stock price is high, given any choice in the matter.

As mentioned:

In terms of the underlying stock price, yes, it's a wash.
But you're also an "investor" in a lot of time value in the options.


During a roll, you are neither a buyer nor a seller of intrinsic value. The stock price doesn't affect that either way, as it always cancels perfectly.
The only concern is the cost of the (net) time value you are purchasing.
For in the money calls, that's minimized on calm market days when the stock price is as high as possible.

Nothing magic about it...a roll is just a thing you gotta do if your position lasts more than two years, like renewing your mortgage.
Just imagine that mortgage rates varied a lot with your LTV (as they should, of course), and you could pick your renewal date.
You'd want to renew at a time that your house appraisal is high.
This is, of course, the exact opposite of what you want the date you're *buying* a house.

Jim
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When is 2:1 leverage appropriate?

The prudent investment advice answer: never.

My greedy risky answer: when you're sufficiently confident that the price is so low relative to value that it's a slam dunk that the price will be higher in a couple/few years.

(And that the value isn't going to fall, and that the leverage is cheap, and that the loan built
into the leverage can be renewed for as long as you need it, and that you'll have the money to pay for that leverage).

In the real world, I think Berkshire is worth going 2:1 when the price to (most recent) book ratio is near or below 1.25, as it was at Christmas.
Maybe even up to 1.3, if you're OK for cash and don't have other solid investment choices with good prospective returns from current prices.
Today's figure is 1.317.

This presupposes that the investment strategy matches your temperament.
If you start at a cheapish valuation level you know pretty much for sure you're going to do well
on average in the next few years, but you have no idea which specific years it will happen.
My philosophy is that you can have at most two of: high returns, safe returns, and steady returns.
This approach is, say, >95% safe, high, and not at all steady.
You can go four years making nothing. The fifth year will likely then be spectacular.
I made more on Berkshire in 2013 than I did in the prior six years combined.
The P/B at end 2012 was only 1.20, so the odds favoured a good stretch coming.
The same had been true at end 2011 at P/B 1.18, but the good stretch didn't arrive in 2012.
The cheaper it is, the more likely you'll see a good payoff soon, but sometimes patience is needed.

I've owned Berkshire for 17.5 years. The method of investment and the position size have varied, but I've always been long.
I overpaid a bit when I originally bought, at P/B 1.67. Buy and hold return since then has been 9.05%/year.
My IRR has been 20.1%, due to some successful buying on dips, some judicious leverage, and occasionally some injudicious leverage.
I haven't let it fully compound...on a fairly regular basis I take money out and spend it.

Jim
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I haven't let it fully compound...on a fairly regular basis I take money out and spend it.

Yeah, isn't it a bitch when the bank calls you up and tells you to come quick because your account is overflowing all over the lobby?

############################################
"Renewing a mortgage?"

Huh. The US has the best home mortgage system--for the borrower. Fixed rate for 30 years, non-callable, refinance at your discretion whenever rates drop.

Speaking of loans & interest rates....
Alliant Credit Union is now paying 2.1% interest on savings accounts.
My car loan rate is 1.99%.
And people said I was silly for buying the car with a loan instead of paying cash. I included the taxes and title/license fees into the loan, too.
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"Renewing a mortgage?"
...
Huh. The US has the best home mortgage system--for the borrower. Fixed rate for 30 years, non-callable, refinance at your discretion whenever rates drop.


Probably a better way to say that is "The US government has the best home mortgage system--for the borrower" : )

I add that because it has nothing to do with the free market, really. The US system is lefty enough to make a Canadian or most Europeans cringe.
No sane private individual or company would lend for 30 years with no inflation protection at these rates. Or even at rates of 25 years ago.
Actually, it always surprises me that more Americans aren't screaming "socialism"! (meaning that as a bad thing)
But I guess the mood is determined mainly by those who benefit from having a government run and government subsidized housing market.

<DIGRESSION>
The underlying policy goal of subsidizing (forcing) very high rates of home ownership has always struck me as containing a lot of cargo cult reasoning.
Sure, homeowners generally are better and happier citizens, with their acts together, on average.
But which way does the causality flow?
I think some people have their act together.
Many of those people can and do buy houses, in large part because they have the means and relatively stable lives because they have their act together.
But it occurs to me that putting a person outside that group into home ownership doesn't ipso facto make them a person with their act together.
Some places have very high rates of home ownership and many non-functional residents. Some places like Germany have the reverse.

I perceive the same with some large fraction of university degrees, being more a signifier of ambition and intelligence and wealth than a causer of those things.
If a degree has been the quick proxy for saying you're in the top 20-25% of the population on those metrics,
then introducing subsidies to get that check box for a larger fraction of the population doesn't do what you might at first think.
It just means the top 20-25% are harder to spot so easily, or they need to have a different quick signifier like attending a more expensive university or getting a graduate degree.

But getting way off topic...
</DIGRESSION>

Jim
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<DIGRESSION>
Yah. “Reynolds’ Law.” Named after Glenn Reynolds (instapundit)

“Subsidizing the markers of status doesn’t produce the character traits that result in that status; it undermines them.”

https://philoofalexandria.wordpress.com/2010/09/25/reynolds-...


No sane private individual or company would lend for 30 years with no inflation protection at these rates.
No shite!! But that system was set up before I was born, so it's the water we swim in.
</DIGRESSION>
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During a roll, you are neither a buyer nor a seller of intrinsic value. The stock price doesn't affect that either way, as it always cancels perfectly.

Okay, I got your point.

But I'll add that I'm with Ray on this. A roll is a combination of two transactions. The higher the current price, the closer you are to a point where is makes sense to sell without rolling. So yes, IF you're going to roll, a high current price and a calm market is a good time for rolling, unless the price is so high that you shouldn't be buying that next contract at all.

Elan
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I've also wondered why we treat houses and home owning so differently here and who would write a 30 year fixed mortgage. But I have profited from the system.
I've also wondered why young people want their own homes, especially when long term one place employment is much less common. Many people who can afford a mortgage and other initial costs may not then have the liquidity to cover the pesky ongoing maintenance and repairs. Property taxes have no limit in most states, so they also can make quite a dent in one's bank account.

rrjjgg
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My car loan rate is 1.99%.

The last two cars I bought were at 0% interest. What's the incentive for the car company?

DB2
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The last two cars I bought were at 0% interest. What's the incentive for the car company?

If the car company manufactures a lot of cars, but the dealers cannot accept any more because they have not yet sold the ones they have and their sales lots are still full, one way to keep their lots from looking full of unsold cars is to sell them to people who cannot afford them. 0% interest on car loans will, they hope, induce people who cannot afford them to by these cars so the manufactures can clear out their own lots.

Investors in car companies do not like the shares of companies that cannot sell their cars.

7 million car "owners" are over 90 days late on their car payments. An unfortunate effect of making loans to people who cannot pay them.
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The last two cars I bought were at 0% interest. What's the incentive for the car company?

It's like the "free" shipping for mail order items from ebay and China. Like the "no luggage fee" for Southwest Airline.

It's not 0% and it's not free. It's buried in the price.


I often see two Ebay listings for the same item from the same seller, with different prices--one with free shipping and one with a shipping cost. The cost of the latter item + shipping is exactly the same as the price of the item with free shipping.
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Latest BRK shareholders' letter holds some interesting observations vis a vis Jim's strategy using BRK and option purchases. I cannot figure out if their suspension of price/book reporting coupled with their ongoing strategy of stock repurchases (which lowers book value) will have a positive or negative effect on the strategy. Going forward, will BRK have permanently higher P/B, thus rendering the option strategy less useful?

I breathlessly await Jim's perspicacious analysis!
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Silly me. He answered the first part of my question in his original post on the subject Post 273343. Guess they've been doing buyback x6 years with 20% of the time at this PB level. Regardless, can 3rd party analysts be accurate in their estimates of p/b if BRK itself does not report on this?
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Regardless, can 3rd party analysts be accurate in their estimates of p/b if BRK itself does not report on this?

Sure.
Calculating book per share is dead easy whether they report it or not.
"Berkshire shareholders equity" from the balance sheet divided by share count on the front page of any quarterly report.
Effective number of shares = number of A shares + (number of B shares/1500).

The question is purely one of how much meaning to assign to it.

For the longest time, give or take, it was a not bad proxy in any given year for the increase in the value of the firm in that year.
Over long periods value rose a bit more than book, but in shorter periods it mostly worked pretty well.
But as the nature of the firm has slowly changed, they have become less like a fancy closed end fund where NAV is easy,
and more like a typical large operating company where earnings and their trend matter more than book value.

In the simplest view that has any merit, a "value on book" firm is worth book, or a bit more if they're outperformers,
but a "value on earnings" firm is worth, say, 10 times the estimated earnings five years from now.
(A cash cow gets a multiple of 10 on current earnings and firm growing at 15%/year gets a multiple of 20)
They have been very gradually shifting from the "book" type of firm to "earnings" type as their stock portfolio becomes a gradually shrinking fraction of the firm's value.
So, the fair price to book value is *very* slowly creeping upwards.

I don't actually agree with Mr Buffett that much on discontinuing the recommendation of the book metric, as the shift is so gradual it's still not *that* bad a yardstick.
But the trend of book/share being less meaningful is certainly there, and one would have to call quits eventually.
If the average S&P firm gets $over $2 of market value for every dollar retained and reinvested, why shouldn't the operating divisions of Berkshire?

The most interesting thing about the annual letter that just came out is that Mr Buffett proposes
a rather different way of valuing the firm, which is certainly pretty simple.
I believe Berkshire’s intrinsic value can be approximated by summing the values of our four asset-laden
groves and then subtracting an appropriate amount for taxes eventually payable on the sale of marketable securities.

He provides the current after-tax-and-everything earnings figures for three of those, and the market value for the fourth.
The unstated but reasonable assumption that the last one, cash and short-term fixed income, is simply worth face value.
I'll have to ponder this view a bit.

Jim
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It's an interesting question. Paraphrasing:

Book value has lost the relevance it once had because:

1. Berkshire has morphed from marketable stocks into operating businesses.

2. Those operating companies' book value is below their intrinsic value, so therefore

3. Repurchases will take place at prices above book value but below our estimate of intrinsic value.

Even though BRK favors businesses that are more about established markets and less about promising futures (Finally an Apple now, but never anything like Amazon), book makes less sense when a free market is not setting that book value.

The most interesting thing about the annual letter that just came out is that Mr Buffett proposes a rather different way of valuing the firm, which is certainly pretty simple

I'd be very interested to see what you might come up with there, Jim.
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1) I just use the PriceBook field at portfolio123. It currently shows 1.35, which is the same ad Jim said. I believe it would be from the quarterly report.

In mid to late Feb we were all tossing around P/B on BRK in the low 1.30's, but looking at the referenced chart (https://ycharts.com/companies/BRK.A/price_to_book_value) I don't see those numbers for that period. At Morningstar it shows 1.42, and we're mostly down in price: http://schrts.co/KnBhhAJz, https://www.morningstar.com/stocks/xnys/brk.a/quote.html

Did Book go down between this discussion and now? P/B got retroactively revised upward in the ycharts data above, or am I missing something?
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In mid to late Feb we were all tossing around P/B on BRK in the low 1.30's, but looking at the referenced chart
(https://ycharts.com/companies/BRK.A/price_to_book_value) I don't see those numbers for that period. At Morningstar it shows 1.42...


I track this fairly assiduously, with particular care given to statement release dates.
That matters because known book per share jumps around a bit. It's really just statistical noise in the broad sweep of history, but it does change.
It dropped an unusually large amount recently with the release of the 2018 year end statements.
Down 7.1% compared to Q3, though up a bit for the year.

Using for each date the most recently available published value for book per share, and closing prices only, for the last few months:
P/B bottomed at 1.231 on 2018-12-24
Average for November: 1.417
Average for December: 1.312
Average for January: 1.314
Average for February: 1.371
Average for March: 1.429

Known book per share dropped quite a bit when the year end statements came out, mainly because of the drop in market prices of some of the stock portfolio.
Underlying earnings, the cash balance, and any reasonably prudent estimate of the true fair value of the firm actually rose in Q4. They make an awful lot of money every week.
But book per share doesn't always catch that.

Average in the month prior to the year end statements which came out on Feb 23: 1.341
Average since the year end statements came out about a month ago on Feb 23: 1.428
Low since the year end statements came out on Feb 23: 1.403 (even though the average price has been 1% higher)

Average P/B since 2010: 1.363. Fifteen year average: 1.430.
Today's close: 1.408. A good buy (I bought shares today), but neither unusually high nor unusually low.

If the current year resembles the past 15-20 years, today's price is consistent with average one year forward returns of inflation plus 5-10%.
The range depends on the specific valuation metric and lookback length you consider.

My nervy prediction since mid last year has been that B shares would trade under $200 less than two months, in total, ever in future.
Though they might trade at arbitrarily low prices, the underlying theory is that such a situation wouldn't last long.
So far we're just over one month total and counting.

Jim
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Known book per share dropped quite a bit when the year end statements came out, mainly because of the drop in market prices of some of the stock portfolio.
Underlying earnings, the cash balance, and any reasonably prudent estimate of the true fair value of the firm actually rose in Q4. They make an awful lot of money every week.
But book per share doesn't always catch that.


Good to know and an interesting problem. To Warren's point, mark-to-market now makes book a bit dubious to look at. In a falling market we will have last quarter's higher book under today's lower market price, giving the tempting illusion of a cheap P/B. In a rising market P/B will appear as always-out-of-reach expensive.

The most interesting thing about the annual letter that just came out is that Mr Buffett proposes a rather different way of valuing the firm, which is certainly pretty simple.

"I believe Berkshire’s intrinsic value can be approximated by summing the values of our four asset-laden groves and then subtracting an appropriate amount for taxes eventually payable on the sale of marketable securities."

He provides the current after-tax-and-everything earnings figures for three of those, and the market value for the fourth. The unstated but reasonable assumption that the last one, cash and short-term fixed income, is simply worth face value. I'll have to ponder this view a bit.


Might be time to take a look at such alternative approaches.
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Jim,
"Right now I'm seeing the lowest estimated interest rate at strike $120 (3.98%), but the bid/ask at that strike is lower than the surrounding ones so it may be a head fake as suggested above.
At the time I did my snapshot there are only 11 contracts offered at the ask, far less than the 100+ at several surrounding strikes.

Jim "


This calculation demonstration in the full post caused some alternative neurons to connect. BRK.b has been above $120 since early 2014. Current BV is $200 plus with announced price support buybacks at prices near that level from the cash rich company. Which leads to the idea that buying the BRK.b and selling the two year calls for a 4% - 5% annual yield could be a good replacement for a portion of a laddered bond portfolio. Return is about twice current treasury yield.
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