Buffett’s $40 Billion Bet on Volatility

Warren Buffett’s track record is unmatched. His recent bullishness on stocks has been unmatched as well. Over the past few weeks, the market has made him pay for being bullish in a bear market.

Whether it’s justified or not, Berkshire Hathaway (NYSE:BRK-A) has finally started to get hit by the sell-off. Yesterday, shares of Buffett’s holding company slid 11% and fell another 12% in early morning trading this morning. The most cited reason from the slide was nervousness over Buffett’s recent $40 billion gamble.

You see, Buffett’s not just buying stocks he likes when they’re undervalued. He’s doing quite a bit more. He’s taking advantage of what the market is offering up investors with the capital and the time to make an absolute killing here. In fact,

So far, Berkshire cut a deal with Goldman Sachs (NYSE:GS) that will likely go down as one of the greatest deals cut during the financial crisis. Whether Warren Buffett’s Goldman Sachs deal it works out or not, the risk/reward ratio was, and still is, stacked in Berkshires favor. It has done a similar deal with General Electric (NYSE:GE) and took some big stakes in a few more companies.

In addition to that, he’s taking full advantage of the Bull Market in Volatility we talked about a month ago. Many investors have used the S&P 500 Volatility Index (VIX) as a gauge of the amount of fear built into the market. In early October, when fear was at unprecedented levels, the VIX was setting new all-time highs.

But the VIX doesn’t necessarily mean it’s time to buy stocks or there’s no more downside left to go. It’s a direct measure of the cost of portfolio insurance. If the big institutional investors, which are the primary buyers and sellers of the S&P 500 Index options, are all demanding insurance against a market panic, insurance premiums are going to be pretty high. That’s what the VIX measures, the cost of insurance.

So what would someone like Buffett who has been in the insurance business for decades do when the cost of insurance is high? He would sell insurance. And that’s what he recently did that has so many investors worried about Berkshire Hathaway.

About a month ago Buffett was sold about $40 billion worth of insurance against the four major indices in the world. The European-style options (which can only be exercised on their expiration dates) were written (sold) are against four major international indices including the S&P 500. The options will expire between 2019 and 2027.

It’s reported Berkshire received $4.5 billion cash for writing these contracts. Considering the contracts don’t start expiring until 2019, Berkshire is free to do with what it sees fit with the cash.

The short-term impact of being on the wrong side of the put options has caused investors to flee Berkshire shares. After all, they got the $4 billion cash, but if the markets crash, it could be on the hook for as much as $40 billion.

As a result, creditors are getting very worried. Forbes reports in Betting Against Buffett, the credit default swaps (the cost to ensure $10 million against a Berkshire default) is now $440,000. That puts the cost of insuring against a default of Berkshire’s top-rated debt right up there with GE, Goldman Sachs, and Citigroup.

In the long run, this all just shows the absolute short-sightedness of Wall Street. It’s a fantastic move over the long run. Berkshire just collected a $4 billion cash infusion which is can use to buy up great stocks very low prices and wait out the next decade.

It may seem like an exotic move to some, but once you actually look at the numbers and risk, it’s actually much more prudent than investors are willing to give Berkshire credit for over the short-term.

As usual, it looks like Buffett scores another big score in this turbulent market and it’s only a matter of time until the investment community realizes it. At this time, if you’ve got a multi-year time horizon and are using a conservative investing strategy that always keeps cash on hand for the enticing opportunity to buy lower, I’d consider starting to look at shares of Berkshire Hathaway.

Over the past decade they have routinely traded at a 40% premium to net asset value. That is a very high premium to pay. It’s much lower now. The fear and uncertainty over Berkshire and the world’s greatest investor’s moves is unwarranted. Either the U.S. is headed for a decade-long depression or we these are going to pay off well.

By Andrew Mickey

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