Buffett's Clue to Bigger Profits

Tucked away in Berkshire Hathaway's (NYSE: BRK-B) 2008 Shareholder Letter, Warren Buffett provided a fascinating insight that applies to an area of the market that most investors never look at, but that may offer some good or even great opportunities right now.

In the letter, Buffett wrote:

The Black-Scholes formula [for valuing options] has approached the status of holy writ in finance. ... Key inputs to the calculation include a contract's maturity and strike price, as well as the analyst's expectations for volatility, interest rates and dividends.

If the formula is applied to extended time periods, however, it can produce absurd results. ... Though historical volatility is a useful -- but far from foolproof -- concept in valuing short-term options, its utility diminishes rapidly as the duration of the option lengthens.

Buying a call option gives you the right to buy an asset at a predetermined price (the "strike") on or before a given date. Buffett made these points in reference to some very long-dated options (i.e., the options expire at a future date that is years away) that Berkshire has sold on several major stock indexes. Individual investors, on the other hand, can trade LEAPS -- which are long-dated options on stocks. Right now, there may be an opportunity for investors to magnify the returns they could earn on buying the stock by purchasing LEAPs instead.

Choose carefully
How do you select which stocks you want to buy LEAPs on? I'd restrict myself to purchasing LEAPs on stocks that Is thought were undervalued. If the stock achieves its intrinsic value before the option matures, you are almost certain to see huge gains (keep in mind that if the stock doesn't reach the strike price, you lose the full amount you paid for the option). Right now, the most undervalued segment of the stock market is high-quality large-cap stocks -- just the sort of stocks Buffett likes for inclusion in Berkshire Hathaway's portfolio. In the table below, I've tried to quantify the upside on LEAPs on six stocks that Buffett owns. I assume that the shares will appreciate 25% between now and January 2013 -- that's an annualized growth rate of roughly 15%.

Source: Yahoo! Finance.

Is this a realistic scenario?
The returns dwarf the hypothetical 25% on the trade, sure, but the shares would have to rise by 25% to harvest those profits. What are the odds of that? Let's assume the companies grow their earnings at a rate equal to the consensus estimate for next year's growth rate. In that case, the required increase in the price-to-earnings multiple of the shares that will get you to a 25% increase in the shares is very small (no more that 10%). In fact, for Johnson & Johnson, the multiple doesn't have to go anywhere; earnings growth can pull the share price up on its own. By the way, each of these shares currently sports a multiple that is in the bottom quartile of its 10-year history.

Stock options can provide you profit-making opportunities, but you need to select your underlying strategy carefully. That demands time and expertise, which is exactly what Jeff Fischer brings to Motley Fool Options, a service in which he's compiled an amazing record of consistent gains. Of the 30 completed trades at May 31, 29 of them were closed at a profit, for an incredible 97% success rate.

A risk-free step toward options success
If you'd like to learn more about adding low-risk option strategies to your portfolio, give Jeff your email address in the box below and you'll receive -- at no cost or obligation to you -- the Options Insider Playbook. You'll also get access to three videos in which Jeff discusses option strategies. This should be an easy call: What's the downside to learning about a new tool for your investor toolkit?