A common conversation among investors these days is whether they should sell their stocks and move to cash, or hedge against a potential decline.
So many people have made so much money in such an unusual time that the market resembles an ATM. Put a dollar in today, and in a minute, hour, week, or month, it magically grows into something more. Yet the real world is odder and odder.
In major U.S. cities, people with different political views dress up like Rambo, arm themselves as if they are headed to war, and face off against each other as even more heavily-armed federal agents emerge from the sidelines to maintain the peace, however that may be defined.
Meanwhile, the U.S. has been hobbled by the coronavirus, and the federal government is again about to flood the economy with trillions of dollars to prevent economic and financial catastrophe. And for that, the stock market continues to be carried higher by a handful of stocks, including Alphabet (ticker: GOOGL), Apple (AAPL), Amazon.com (AMZN), Microsoft (MSFT), and other tech names.
Strategists who were helping investors find stocks to profit off Covid-19-triggered changes in working and living are now increasingly dealing with clients wanting to hedge their portfolios. Yet everyone is discovering that hedging is expensive, perhaps too costly if the stock market fails to lose 25% or more of its value.
As this hedging conversation occurs, one of the world’s most admired investors has finally revealed what’s on his mind. Warren Buffett’s Berkshire Hathaway (BRK.A) bought $1.2 billion of Bank of America (BAC) stock from July 20 through July 27, paying an average price of $24 a share.
Berkshire now holds 998 million BofA shares worth $25 billion, making it Berkshire’s second-largest equity holding behind Apple.
Buffett’s decision to buy a weak stock is noteworthy when so many others are talking about hedging. In fact, it’s hard to recall a time when Buffett has not chosen to make major purchases when the market was weak.
Buffett’s actions reinforce the notion that it is arguably better to buy fear than to hedge fear. Aside from the expense of hedging, which can depress portfolio returns, hedgers have to be right on the timing. The more time packed into the hedge, the more expensive the hedge.
While it sounds catchy to describe the stock market as having become “antifragile”—able to withstand social and financial chaos—it’s truly difficult to have such confidence about something as diverse and complicated. Instead, it’s better to focus on stocks, which are more knowable.
In that spirit, let’s reconsider Bank of America, a company we have championed since the darkest days of the financial crisis, well before Buffett became its most famous shareholder. When it seemed as if the bank might go under, we championed it and CEO Brian Moynihan, and encouraged investors to build positions when the stock was trading close to zero.
Now, after more than a decade, Bank of America is in a very different place, though the shares are again weak as the Federal Reserve once more reduces rates to support a wounded economy and financial system.
With the stock at $24.71, investors could sell BofA’s September $25 put option for $1.31.
So far this year, Bank of America’s stock is down 30%. Over the past year, the stock is down 18%. During the past 52 weeks, the stock has ranged from $17.95 to $35.72.
If the stock is below the strike price at expiration, investors buy the stock. Should the stock be above the strike price at expiration, investors keep the put premium. The key risk is the stock falling far below the strike price, obligating investors to buy shares at the higher strike price. Even if the stock falls below the strike price, don’t fret. Remember what Buffett does: He uses weakness to his long-term advantage.