The "Pretend You're Warren Buffett"
Approach to Leveraged Investing

by

Brad Castro

Disclaimer: Before I proceed, I want to make it clear that I’m not a broker or investment advisor and the only license I possess is the one that legally authorizes me to operate a motor vehicle. What follows is not a recommendation related to any specific security, but is included for illustration and education purposes.

Warren Buffett’s Background and Investing Style

Buffett has always focused on strong cash flow operations. From the original textile, Buffett expanded into the high cash flow insurance industry. Investing the float (insurance premium payments received but not yet paid out in claims) to masterful, compounding effect, Berkshire Hathaway is now a cash-producing behemoth.

There are two types of Berkshire Hathaway companies—those Buffett has purchased in their entirety (such as wholly owned subsidiaries GEICO, Sees Candies, and Pampered Chef) and publicly traded companies in which Buffett has taken large equity stakes (such as Coca-Cola, American Express, and Burlington Northern).

The Pretend You’re Warren Buffett Approach, out of necessity, focuses only on the second category of companies. Unfortunately, acquiring wholly owned subsidiaries through the strategic use of options is, at this time, beyond the scope of this website. Alas!

Size Matters

Due to Berkshire Hathaway’s enormous balance sheet and cash reserves (routinely in the tens of billions of dollars), it’s just not practical for Warren Buffett to invest in anything but large scale opportunities. No matter how great the returns on a small cap investment are, they probably aren’t going to have much of a material impact on the Berkshire Hathaway bottom line.

So if you choose to adopt The Pretend You’re Warren Buffett Approach, be aware that the literal application means you’re going to be limiting yourself to investing mostly in large cap stocks.

Of course, as a self-respecting and self-directed investor, you are always free to modify the stock selection process to include other companies in other market capitalization categories (i.e. if you care to speculate on what specific, smaller companies Buffett might consider if he had less money to invest - but be aware that the options on many small cap companies are too thinly traded to be effective Leveraged Investing candidates).

Stock and Option Selection

Berkshire’s largest holdings (those with a minimum of $600 million market cap) are itemized in the Shareholder Letter section of the company’s annual report.

But the best resource I’ve come across, by far, is from CNBC. They maintain a live table of all Berkshire holdings based on SEC filings and current share price. This table is more complete (obviously) than the itemized list included in the annual report, not to mention more interesting.

It’s also enables you to be more flexible by including some of the other smaller holdings. I believe I read somewhere once that approximately 80% of Berkshire Hathaway equity holdings are comprised of only about six companies.

The Approach Spelled Out

As you review Berkshire’s current holdings (see links above), it's important that you do your own due diligence, both from a fundamental analysis of a Berkshire company's long term growth and viability as well as its current valuation.

True, this approach relies a great deal on Buffett for an initial basket of stocks from which to select. But when it comes time to the actual selection, this is your decision, and you are the only one who is ultimately accountable for making it.

So conduct further research, do your own due diligence, consider current valuations (i.e. price), and then and only then employ your preferred strategies from the The Essential Leveraged Investing Guide on the Buffett stock(s)you would most like to own.

The principles of Leveraged Investing are as sound as they are powerful. If you can reduce the cost basis on your long term holdings by just 5-10% a year, and if you employ these strategies on solid, long term, superior businesses (e.g. the kind Buffett owns), you're going to do extremely well over the long term.

[Reducing your cost basis? Is it really possible to adjust or lower the cost basis on your long term holdings after you've acquired them? Not only is it possible to lower your cost basis after you've acquired shares, it's also possible to lower your cost basis before and during, too. For more details, check out the related article, Adjusted Cost Basis with Options.]

Final Thoughts

But remember, this strategy is about pretending you're Warren Buffett, not actually becoming Warren Buffett. And pretending, at some level, is supposed to be fun.

That's not to say this is a useless approach. On the contrary, part of the fun is that you really are using options to get a lot closer to Buffett's investing style than 95% of the other market participants.

And I should also point out that Buffett has used put writing strategies himself to acquire positions (and very large ones, I might add) in Coca-Cola. So this approach really isn't that much of a stretch.