Taking the opposite side of Warren Buffett is one of the market’s most uncomfortable positions. Still, there is one element to Buffett’s thinking about his management of Berkshire Hathaway that frequently frustrates many of his investors.
Unlike many stocks in Berkshire’s blue-chip investment portfolio, Berkshire itself doesn’t pay dividends to shareholders. Buffett has consistently used the money that would have been paid to shareholders to invest, making more money than they would have received in dividend income.
Yet Buffett’s legendary stock-picking prowess has done little to stop many investors from wanting a dividend that would turn the great stock into an income generator—especially as the company’s cash hoard has grown to nearly $350 billion. In addition, many Berkshire investors have owned the stock for years, and that means they bought at sharply lower prices, so selling would trigger big capital-gains tax bills if they sold stock to raise cash.
The absence of a dividend is likely to become an even larger issue for shareholders since Buffett just announced he would retire as CEO at the end of the year. His handpicked successor, Greg Abel, may lack Buffett’s wizardly ways of making money—and shareholders may want the extra assurance of a dividend.
Here’s a way to create a “conditional dividend” with options on a stock that doesn’t pay a dividend.
With Berkshire’s B shares at $512.33, an investor could sell a June $545 call option to generate a “conditional dividend” of about $4. If the stock remains below the $545 strike price, investors keep the options premium. Should the stock be above the strike price at expiration, the investor can adjust the position to avoid selling stock or let the stock be sold. (Calls give buyers the right to buy an asset at a set price and time.)
The trade-off between a conditional dividend and managing an options position is complex. Investors can use options to turn unrealized gains into an income-generating stock—with important caveats.
Dividends are taxed at 15% on stock owned for more than a year. Equity options that expire in less than a year are taxed as short-term income, unless the trades are conducted in tax-advantaged accounts. Also, selling calls on stock sometimes creates risk. The stock could rise above the call strike price. If that happens, investors face three choices:
They can buy back the call for more money than they received when they sold it, and use the loss to offset tax liabilities, or they can sell stock, which would likely trigger a tax bill. Check with your accountant to confirm tax treatment.
The third option—let’s call it the “schnitzel”—is a personal favorite that lacks widespread appreciation.
Many investors own odd numbers of shares, and that creates a way out for options sellers managing income programs. For instance, a position of 1,070 Berkshire shares means that 70 shares can be “schnitzeled.” The strategy is named after the popular German dish, because selling odd lots “thins out” the stock position—and that’s OK.
Options contracts equal 100 shares. But the odd lot—anything below 100 shares—can bail you out when the stock price runs past the strike price. Investors can raise money by selling those shares—“schnitzeling”—to buy back the call or lower the cost of rolling the call to a higher strike price.
Investors can debate if the time needed to manage conditional dividends is worthwhile, but remember: Dividends account for about 40% of historic stock returns—which means a large chunk of investing success comes from owning quality businesses that pay dividends. Reinvesting dividends also helps to compound returns, and that is almost as profound as Buffett’s genius for making money.
Email: editors@barrons.com