Buffett Likes to Be Early, Don't Be Too Hasty In Following Him

Warren Buffett wrote an op-ed in the New York Times, announcing that he's selling US bonds in his personal account and buying American stocks. Equities will outperform cash in the next ten years, he says. Naturally, everyone's excited.

In investing, Buffett says he follows Wayne Gretzky's advice: "I skate to where the puck is going to be, not where it has been." A perhaps better analogy of Buffett's investing style is getting to a New York City subway station before the train arrives. Unlike Gretzky's puck, which takes a second or two to get to where the hockey great expects it, the wait for an MTA subway train can take hours. Buffett gets to the subway station extra early (some of his recent stock purchases):

NRG Energy (NRG)
Bought: $40 to $44.43 a share
Last close: $18.18

Sanofi-Aventis (SNY)
Bought: $32.32 to $38.04 a share
Last close: $29.08

Burlington Northern (BNI)
Bought: $76.65 to $91.99 a share
Last close: $80.47

Kraft (KFT)
Bought: $28.56 to $31.66 a share
Last close: $27.50

US Bancorp (USB)
Bought: $29.07 to $34.09 a share
Last close: $30.87

WellPoint (WLP)
Bought: $43.23 to $87.63 a share
Last close: $39.92

UnitedHealth (UNH)
Bought: $34.37 to $55.95 a share
Last close: $22.63

For Berkshire's 2008 stock purchases, it appears that only Wells Fargo (WFC) is in positive territory since Buffett added shares. (Buffett did use a subsidiary to purchase a 10% stake in Chinese battery maker BYD, which doubled after the deal was announced, but the above is a partial list of Buffett's domestic stock purchases.)

This is all to say that just because Buffett's buying now it doesn't mean you have to rush to buy stocks. There's plenty of time to do thorough research before jumping in. And when you do jump in, don't buy everything in one order. It's best to do it over a number of days, weeks, or months.

There is much speculation as to which stocks Buffett is buying for his personal portfolio. Names like GE, Wells Fargo, Coca Cola (KO), and Kraft are being thrown around. Buffett may indeed be buying these, as he's said to be a creature of habit.

It's likely, however, that Buffett is also buying small and mid cap stocks. Buffett has previously said that he would generate annual returns of 50% if he had smaller sums to invest. Given that he has far less cash to put to work than Berkshire, Buffett isn't restricted to large caps. Small and mid cap stocks have a much higher gain potential. For example, investors have to put around $200 billion into GE for it to double. A stock with a market cap of $1 billion, on the other hand, would only require investors to put in $1 billion for it to double. It would grow 200 times on the same amount of capital required for GE to go up two times.

Yes, the best time to buy stocks is when there's panic in the streets. But don't rush, and don't spend all your money in one place or at one time.

Disclosure: I owned no stocks mentioned above at the time of writing.


Using Covered Calls to Increase Your Dividend Yield During a Bear Market

There are a number of covered call income strategies. A traditional strategy is buying a stock and writing out of the money near or midterm calls on it. The goal is to keep the stock for the long term while generating income from it. Another strategy with a similar goal is buying deep in the money LEAP calls and selling near or midterm out of the money "covered" calls on them.

With stocks that pay dividends, investors may prefer the former strategy--you get income from both dividends on the underlying stock and from your calls. A problem that investors can run into with this strategy is that if their stock falls they may either have to write calls on lower strikes (taking a risk that the stock will be called from them for lower than they bought it) or sell longer term calls to get the same income.

Here's another way to get a decent income from dividend paying stocks that mitigates the above problem somewhat. Buy the dividend paying stock, and write a deep in the money LEAP call on it. While this severely limits any potential capital gains, it increases your dividend yield.

Here's an example. Let's say you decide to buy Pfizer (PFE) for its dividend (I don't think it's a very safe dividend, but let's say it is). As I'm writing, Pfizer is trading at $16.94 a share. The Jan '10 call at the 10 strike has a bid of $6.70 and an ask of $7.30. Let's say you're able to buy 100 shares at $16.94 and write a call for $7. Excluding commissions (these can vary, the cheapest I know of is $5 at Zecco), the net debit from your account would be $9.94 per share, or $994.

Pfizer's annualized dividend is $1.28 a share. Assume that the dividend payout will stay constant.

(A) Buying the shares without writing the call would get you a dividend yield of around 7.56%.
(B) Buying the shares and selling the call would get you a dividend yield of around 12.88%.

Scenario A leaves open unlimited capital gains, but offers downside protection of only $1.28 a share per year.

Scenario B limits capital gains to a theoretical $0.06 a share, or $6 in total (depending on broker commissions, the entire transaction will probably result in a slight loss--at Zecco it would be under $5). Pfizer can trade for $10,000 a share, but you'll only get $10 a share for it when the stock is called. Downside protection, however, is much better than in scenario A. As long as Pfizer trades above the price you paid ($9.94 per share plus commissions), you're not losing money, and this does not include the dividends you receive. While certainly riskier than a CD, the 12.88% dividend compensates for the risk rather well. As qualified dividends are charged a max of 15%, you may save on taxes here as well.

A danger with scenario B is that your shares may be called at any time. Here your gain/loss depends on how many dividend payments you have collected and what your commission costs are (update: as the commenter points out at the bottom, in most cases you don't get your annualized dividend all at once. In the case of Pfizer and most dividend paying stocks, dividends come once a quarter). The maximum you can lose if the stock is assigned is commission costs.

To mitigate the assignment risk and make the strategy in scenario B worthwhile, only do the deep in the money covered call write when the net debit from your account is less than the amount you will receive when/if the stock is called. While the Pfizer transaction above is an example, the $0.06 difference is not very much, and you will lose money on the enterprise if your shares are called too early (before your first dividend payment). A better example is Johnson & Johnson (JNJ). As I'm writing, JNJ is trading at $62.18 a share. The bid for the Jan '11 50 strike call is $14.80, and the ask is $16. Let's say you are able to buy the stock and sell the call, incurring a net debit of $47.39 per share. If the stock is called (which it will be if it's $50 or above when the call expires), you will receive $50 a share for it, giving you a capital gain of $2.61 a share (minus commissions).

As far as when to use this strategy, a bear market is the best time. As mentioned above, the traditional covered call strategy may run into problems when the underlying stock falls below your purchase price. During bear markets this possibility often comes true. This strategy is only worthwhile with dividend paying stocks. As with all stocks you buy, do your research. Don't use this strategy just because the spread between your net debit and the strike price is high (though this may be a good trade for gambling purposes).

Traditional covered call and LEAP "covered" call strategies work best in flat and slightly uptrending markets (if you don't mind getting assigned, raging bull markets work too). These strategies do not require dividend paying stocks to work.

To see this strategy in action, check out what I'm doing with Wells Fargo (WFC).

Disclosure: At the time of writing I owned JNJ.


Don't Forget Credit Card Losses

There's finally talk about credit card defaults. Business Week has a pretty good article on the subject here. Outstanding credit card debt amounts to around $950 billion. About $285 billion of it is subprime, and the defaults are just beginning. As the economy weakens and more people lose their jobs, credit card losses are likely to accelerate. Innovest, according to Business Week, estimates that losses could be higher than $75 billion by 2009.

As credit card debt starts to sour, companies are reducing lines of credit, issuing less cards, and raising their already usurious rates on balances even higher. All this will contribute to a decline in credit card use and profitability. With a lower effective credit limit (whether because their credit line was reduced or their balance is near the limit) consumers will have less purchasing power. This means less swipes at the register. It also means they'll borrow less money.

Banks, like Chase (JPM), Citigroup (C), and Bank of America (BAC), will suffer losses on defaults. Unlike defaulted mortgages, where some of the losses can be recouped through a foreclosure auction, credit card debt has no collateral. They will also lose potential profits because they will be lending out less money. This can become a self reinforcing cycle, as buyers of securitized credit card debt will demand higher yields to compensate for their risk.

American Express (AXP) and Discover (DFS) are in the same boat as the banks above. As they also make money from swipes, less swipes means lower earnings. While American Express has wealthier customers, the downturn in the economy is still having an effect. According to Business Week, the company's provision for losses was $1.5 billion in the latest quarter, up 85%. As almost 98% of Discover's US revenue comes from credit cards, its outlook is not very bright either.

Visa (V) and Mastercard (MA), which issue no debt, will almost certainly be affected too, because of less swipes. Although potentially increased debit card use will likely offset this somewhat, less swipes mean lower earnings.

Disclosure: I don't have any positions in the stocks mentioned above. If the current rally continues, I'll be looking to buy puts on some or all of the following: AXP, BAC, C, DFS.