How Uncertain Is Berkshire Hathaway's Future?
Options are now trading on the Oracle of Omaha's company.
Investing Specialists
On June 18, the Chicago Board Options Exchange listed for trading options on Berkshire Hathaway's B shares, (BRK.B). Berkshire and Buffett had nothing to do with the listing; however, Buffett did recently enter into some large index option positions as I discussed in this article.
We could wade into the uses, suitability, and morality of equity options and Buffett's description of derivatives as "financial instruments of mass destruction," ad infinitum, but the listing of Berkshire Hathaway options enables a much more interesting discussion. Now that we have prices for Berkshire options, we can take a direct look at the market's estimate of the uncertainty around the future price of the shares of the company run by one the world's most successful investors.
The Uncertainty About Berkshire
Option prices are evaluated using a measure of uncertainty known as implied volatility. The more uncertain the outcome for the shares at the time that the option expires, the more expensive the option, and the higher the implied volatility spit out by the famous Black-Scholes-Merton option pricing model.
According to Morningstar's option chains, the implied volatility of the options on Berkshire is 30% as of Friday, June 19, and that is nearly constant across time horizons for options expiring anywhere from one month from now to the longest duration option available, December 2009.
An implied volatility of 30% is consistent with what we consider to be a low to medium uncertainty company, which is exactly what we would expect for a firm like Berkshire, which carries a Morningstar uncertainty rating of "medium." (This article discusses Morningstar's uncertainty rating in greater detail.)
To provide a frame of reference, the Morningstar Volatility Index (MVI), which is a measure of the average implied volatility of all of the options traded on U.S. stocks, is currently 73%. So, the share price of Berkshire is less than half as uncertain as the average company on which U.S. equity options are traded. A simple way to think about this difference is that the market thinks it is possible to bound the share price of Berkshire for the next six months more than twice as tightly as the average company on the stock market.
Trading Costs
For newly listed options with little open interest or volume, the options on Berkshire are relatively inexpensive to trade. As can also be seen on the option chains, the Morningstar Option Expense index (MOE) for each of these options is less than a few percent. This means that a round-trip transaction of buying and reselling the option at the ask and bid price will cost less than a few percent of the value of the underlying exposure. While that may seem like a lot, it is actually relatively inexpensive for illiquid options.
Investment Potential
We think these could pose an interesting investment opportunity. We believe Berkshire shares are undervalued. Although growth opportunities may be limited, the diversified nature and quality of Berkshire's portfolio of businesses, and Berkshire's strong balance sheet, should particularly limit the downside to the shares. This fact makes the 14% annualized premium available for writing December 2009 puts at the current price of BRK.B quite attractive. If an investor is willing to take possession of Berkshire shares, a put writing strategy on Berkshire could be quite compelling. In essence, writing put options on Berkshire is writing insurance on a master insurer. If you wind up owning the shares, we expect the portfolio of businesses to rise to our estimate of fair value over time.
If you are interested in exploring options as an investment vehicle, and Morningstar's unique approach to using fundamental research to invest in options, I encourage you to download the Morningstar Guide to Option Investing.
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