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Warren Buffett and Berkshire Hathaway released their annual letter to shareholders last Friday. There were plenty of useful comments on a wide variety of topics revolving around investing, and this document will be a major part of the conversation of investors over the following weeks ahead.

Warren Buffett touched upon one area in his letter to shareholders revolving around the type of investment that very few investors have in their portfolio: stock options. Buffett has used options to boost the profits of Berkshire Hathaway, and in his shareholder letter, he talks about his belief that options can produce profits of a greater magnitude later on in the future. By making this claim, Warren Buffett calls into question if the entire open market for this type of investment is potentially mispriced – and it creates other opportunities for intelligent long-term investors.

Let’s now take a look into Buffett’s argument a little bit further, and overturn some stones by discussing ways to take advantage of this untapped opportunity.

The Big Bull Market Bet

During the years 2004 until 2008, Warren Buffett and Berkshire Hathaway took massive exposure upon themselves within the options market. They were selling put options on the major stock market benchmarks covering Europe, Japan, the UK and the US. By doing so, Berkshire Hathaway was extending its traditional insurance business to provide protection that is stock market related for its counterparties. Berkshire Hathaway brought in $4.2 billion by selling these put options, and just like the other premiums Berkshire receives from its insurance businesses, they turned around and invested these billions of dollars in sales into its stock holdings and operating companies.

When the market melted down in 2008 and throughout the early part of 2009, the put options looked like a really bad move. At the time, Berkshire Hathaway was sitting on what appeared to be a potential $10 billion loss, with the possibility that the losses would be even greater if the market stayed low past the options expiration dates, which range from the years 2018 through 2026. But at the time of this writing, the current intrinsic value of the options are now below the premiums Berkshire Hathaway received, thanks to the large bull market that’s happened over the last four years. Overall, Buffett expects the final amount due under the options to be a lot less than the current figure of $3.9 billion.

Is There a Flaw in Long-Term Option Pricing?

Brendan Conway of Barron’s posted a fantastic blog post last Friday afternoon, which reminded investors of Berkshire Hathaway of the history behind these Buffett puts. As commonly noted, Buffett has gone to tremendous lengths in one of his previous shareholder letters to describe the inefficiencies and pricing of the options market and how Buffett planned to exploit it.

The root of the options problem lies specifically in the volatility assumptions made in the very commonly used Black-Scholes formula. From year to year or day-to-day, stocks can move rather abruptly, and the assumptions of volatility often are baked into the price of options. But when you look at them over longer periods of time, stock market returns are much smoother, and Black-Scholes will value options more highly than it is actually appropriate – which makes them much better to sell instead of buy, and this is especially true when you have puts expecting the market to continue to trend upward.

Warren Buffett’s behavior points to a much different view toward trading options for the long term on the buy side. When Buffett has previously provided financing to large corporations like General Electric and Goldman Sachs, he used warrants that are options like, and they provide a long-term equity kicker to Berkshire Hathaway with this investment. By being willing to hold onto these warrants strongly points to Buffett’s belief that volatility on the downside is overestimated, then the upside volatility is also underestimated, which will make long-term call options the better buy for investors.

Can Anyone Take Advantage of This?

The short answer is no. The deals put together by Warren Buffett are not typically available to your average investor. The long-term options available to the public will normally only run just a few years into the future, but that is not a long enough time for an entire bull – bear cycle to run its course for reversion to the mean to take place.

The one place where long-term options are available at this time is in financial stocks. This is thanks to the TARP bailouts, so five to six year warrants are currently available from several major banks and other financial institutions. For Capital One and Hartford Financial, these warrants are already in the money – which means that the current price of the shares already exceeds the exercise price of the warrant. This will limit the impact of volatility estimate errors on the warrant price.

But on the other hand, Bank of America and Citigroup still have warrants where the strike prices are well above the share value at the current market price. With the bulk of the value coming from the time value and the estimates of volatility that are generated, the warrants for these shares are very susceptible to the type of mispricing that Warren Buffett is discussing.

Take a Look for Yourself

Remember that options and warrants are a very specialized type of investment and they present a substantial risk. But regardless, the questions revolved around proper pricing for the long term bring up the possibility that you can use this type of option to your advantage, which means you might want to take a closer look.

The long-term track record of Warren Buffett’s success has made him the best investor of our time, but currently Berkshire Hathaway shares are trading at their all-time high. Is it the right time to buy Berkshire right now? You decide.

Insurance is a big reason why Berkshire Hathaway’s risk-adjusted investment return has been able to beat every mutual fund since the year 1976.

We learn this according to a new research paper from New York University and AQR Capital Management, told by The Economist.

The insurance and reinsurance companies that are part of Berkshire Hathaway lend money to the Berkshire Hathaway parent company, and they actually provide more than one third of the company funding. Buffett is then able to use this leverage as a way to purchase large quantities of stocks as an investment.

“This would be an expensive strategy if the [insurance] company undercharged for the risks it was taking,” states The Economist.

“But thanks to the probability of its insurance operations, Berkshire’s borrowing costs from this source have averaged 2.2%, more than three percentage points below the average short-term financing cost of the American government over the same period.

The insurance company also gives Warren Buffett a way to borrow money during both good times and bad times. “The long-term nature of the insurance funding has protected Mister Buffett during periods (such as the late 1990s) when Berkshire shares have underperformed the market,” states the magazine.

“Without leverage… Mister Buffett’s return would have been unspectacular,” says The Economist.

By having the insurance company leverage available to him, Warren Buffett is able to tap into this resource and by stock shares in high-quality companies that are struggling and going through hard times. He did this with Coca-Cola during the 1980s, and he was also able to gobble up shares of General Electric during the most recent financial crisis, we also learned from The Economist.

The magazine quotes Warren Buffett as saying, “It’s far better to buy a wonderful company had a fair price then a fair company at a wonderful price.”

Buffett has also “steered largely clear of more volatile sectors, such as technology, where he cannot be sure that a company has a suitable advantage,” notes The Economist.

All in all, not everything touched by Warren Buffett turns to gold. Berkshire Hathaway is the biggest shareholder of Moody’s rating company, and they lost roughly $340 million when the stock plummeted 22% last week.

This drop happened because the government is considering suing Standard & Poor’s, a rival of Moody’s, because of ratings practices that they implemented prior to the financial crisis taking place.

Warren Buffett says that US banks are “in the best shape in recent memory,” as he mentions this to Bloomberg News recently. He also believes that they will not cause the next big financial meltdown.

As the CEO and chairman of Berkshire Hathaway Inc., based out of Omaha, Nebraska, Warren Buffett has earned billions of dollars over the past four years when he started investing in Wells Fargo and Company, Goldman Sachs, U.S. Bancorp and Bank of America. Let’s not forget about General Electric as well. They are all companies that operate in the finance industry, and they each fall under the banking category.

And if he wanted to, Warren Buffett could earn another $3 billion right now by cashing in discount stock purchase warrants from Bank of America. He chose to wait instead, and here’s why:

“We’re in no hurry,” said Buffett to Bloomberg. “Nine years from now I would think that Bank of America as well as Wells Fargo and probably the other major banks will be worth considerably more money than they are now.”

Mister Buffett says that the banks are so much more healthy right now since the financial crash during 2008 because they have cleared out the bad loans on their books, rebuilt their capital, lowered their risk, cut their expenses and repaid the taxpayer bailouts throughout a very fragile real estate market.

There are many experts that still worry the biggest banks in the US are too big, and they can easily repeat the same problems that triggered the recession that we went through recently. Buffett doesn’t believe this.

“The banks will not get this country in trouble, I guarantee it… We do not have an unusually concentrated banking system compared to the rest of the world, and there are certain advantages in the largest capital market in the world to having banks that are somewhat consistent with the size of those markets.”

Warren Buffett is a billionaire investor who has taken out stakes in some of the largest United States banks, who tells us that the lenders have rebuilt their capital to the levels where they aren’t a possible threat to the economy any longer.

“The banks will not get this country in trouble, I guarantee it,” said Buffett – the CEO and chairman of Berkshire Hathaway, based out of Omaha, Nebraska – in an interview that he gave over the phone last week. “The capital ratios are huge, the excesses on the asset side have been largely cleared out.”

Major lenders including Citigroup Inc. and Bank of America Corp. have sold off their assets, bolstered their balance sheets and cut many jobs after they repaid the 2008 taxpayer bailouts, when these companies were truly overwhelmed by losses on housing market related securities. All of those actions helped raise the value of Berkshire Hathaway’s holdings, and increase financial stocks at the same time.

Berkshire Hathaway has invested in at least four of the seven biggest lenders in the United States of America by assets, and has also taken out more than a $14 billion stake in Wells Fargo and Co., based out of San Francisco. They have a $5 billion stake in Bank of America, and they have $5 billion worth of warrants to purchase shares of Goldman Sachs Group Inc. Berkshire Hathaway has a stake in U.S. Bancorp as well.

“Our banking system is in the best shape in recent memory,” said Buffett.

Past bank regulators and executives tell us that the biggest lenders still pose some risk to the United States economy even four years after the bailout, plus 2 1/2 years since legislators passed the largest major reforms to regulation on Wall Street since the Great Depression.

Trading Loss

Last year, J.P. Morgan Chase and Co. took a trading loss of $6.2 billion, which reminded America of our concerns for the banking industry. Sandy Weill, former CEO of Citigroup, mentions that lending money and taking deposits should be split off from investment banking as a way to prevent another major financial crisis.

Other investors have also spoke about their doubts and the accounting of banks. Even after the stock rally last year, J.P. Morgan, Bank of America, Goldman Sachs and Citigroup are all trading at less their book value, which is a calculation of how much a company’s assets should be worth if you subtract their liabilities.

There were mergers taking place during the financial crisis that brought about criticism, saying that too big to fail banking companies are getting even larger. Buffett mentions that this shouldn’t worry investors at all. Canadian banks managed to get through this crisis a lot better than other banks in many nations, as the biggest firms in Canada took hold of more market share than their counterparts in the United States did.

U.S. Advantages

“We do not have an unusually concentrated banking system compared to the rest of the world, and there are certain advantages in the largest capital market in the world to have banks that are somewhat consistent with the size of those markets,” said Buffett.

The biggest United States banks are going to face another round of Federal Reserve stress tests to figure out whether or not they have enough capital to raise dividends and buy back shares of their stock. Brian T. Moynihan, CEO of Bank of America, tells us that he’s confident BOA is going to pass even though they failed in 2011, when he did not receive the approval to increase the dividend.

Buffett also lent Bank of America credibility by providing the bank capital during 2011, after the company saw a 45% decline in share price during an eighth month period. This trade also followed moves during 2008 that Warren Buffett made by helping out General Electric Company and Goldman Sachs during the financial crisis. Both of the companies bought back the preferred shares that they sold to Warren Buffett. He also expects that Bank of America may potentially do the same.

Improved Condition

“Their condition has improved so significantly, and interest rates are so low, that they have the chance to do a number of things in that respect,” said Buffett. “I may like to keep it, but if it makes sense for them to call it, they’re going to call it.”

The preferred shares that Berkshire Hathaway owns of Bank of America pay an annual dividend of 6%, and they can redeem them at any time for the amount of $5.25 billion, according to the terms of the deal that was made. The deal also gives Warren Buffett 10 year warrants to buy 700 million shares of common stock from Bank of America at $7.14 apiece. Bank of America recently closed at $11.43 per share. If Warren Buffett were to exercise that option at those prices, he would make about $3 billion.

Buffett mentions that Berkshire Hathaway is most likely going to wait toward the end of the contract before they exercise that option.

“We’re in no hurry,” said Buffett. “Nine years from now I would think that Bank of America as well as Wells Fargo and probably the other major banks will be worth considerably more than they are now.”

A spokesman for Bank of America named Larry DiRita chose not to comment on Warren Buffett’s Bank of America investment.

Their Tier 1 capital ratio has almost reached 9% as of September 30 based on the newest standards internationally, and it’s up from about 8% just three months earlier. Their long-term debt dropped to $286.5 billion by the end of the third quarter, and this is down from $399 billion just one year earlier.

Billionaire investor and owner of Berkshire Hathaway recently dropped a bomb earlier this month.

Breaking with typical Berkshire Hathaway tradition, and changing the rules that Warren Buffett has laid down for himself financially, Berkshire Hathaway is actually buying back some of its own stock – and plans to continue buying back more stock as long as it doesn’t go over the price of 1.2 times book value.

What is book value anyway?

Before a company is assembled into a whole corporate stock, book value is the price of its separate constituent parts. A technical definition of book value is defined like this: “the net asset value of a company, calculated by total assets minus intangible assets (patents, goodwill) and liabilities.”

But don’t let that definition throw you for a loop. You do not need to understand the specific financial aspects of this transaction in order to truly understand what this story represents.

Here’s the most important thing that you need to grasp: not much longer than a year ago, in this past September of 2011, Warren Buffett announced that Berkshire Hathaway is going to buy back its shares at 110% of the book value of the company. This was a surprising move on Buffett’s part because for many years in the past Warren Buffett has been very critical of buying back shares of any company – and how many companies use this as a way to pump up the price of their shares.

Nonetheless, this past September Warren Buffett told the world that he’s going to start buying back shares as well. He also said that he would keep on buying back shares as long as the price was at the level that he was willing to pay, or potentially lower. This could possibly have him buying back billions of dollars worth of Berkshire Hathaway shares, because in Warren Buffett’s opinion the business is “worth considerably more” then the Berkshire Hathaway shares are currently selling.

Now fast-forward to December 2012. Earlier in the month, Mister Buffett also announced that he’s going to take it a step further by paying up to 120% of the company’s book value, which comes out to 1.2 times.

So what exactly does this buyback mean?

You could look at Warren Buffett’s announcement recently in two different ways. If you look at it the first way, according to the way that Mister Buffett would probably spend it, is that Berkshire Hathaway is buying back their shares because they find them at an incredible value according to the current price as of today. And there is definitely much truth to that statement.

If you look back throughout Berkshire Hathaway’s history, you will see that it traditionally sold a lot higher than 1.1 times of the company’s book value, or even 1.2 times for that matter. As a matter of fact, over the last 12 years of the 21st century, the average price of Berkshire Hathaway shares sold at least 1.5 times their book value. And there were even times where the stock occasionally sold for more than double its book value.

So, if you look at Berkshire Hathaway’s shares on the surface, you can see that buying at 1.2 times book value is definitely paying a discount for the shares when you compare it to the usual price. This is about 20% below the average cost.

What else could this move mean to Warren Buffett?

Another way that you might possibly explain this move by Warren Buffett and his decision to purchase more of Berkshire Hathaway stock is by saying this: doing so is actually the lesser of evils.

As I’m sure many of you know, one of the biggest problems Berkshire Hathaway faced over recent years is that it doesn’t know what to do with all of its money. At the time of this writing, Berkshire is currently sitting on $47.8 billion in cash as of now. Since banks are only paying 0.1% interest, he actually can’t afford to just sit on the money. He has to actually invest it into something.

Throughout other portions of the market, we are seeing a plethora of mergers and acquisitions as many other companies throw around bags of cash, by investing their cash in company buyouts.

Over the last few weeks alone, we have seen TJX buy Sierra Trading Post for $200 million. We also saw Oracle buy Eloqua for the amount of $850 million. Avio Aviation was sold to General Electric for a very large $4.3 billion. Since Buffett and company have around $48 billion to invest, they could have chose to make any of these deals without even thinking twice about it.

But they didn’t.

Instead, since Warren Buffett is the smartest investor in the world today, and possibly even the smartest businessman throughout the history of the world – what did he do? He looked around at various investment opportunities on the stock market, noticed that many of the companies there were selling for two times book value, and then muttered to himself “too expensive, too expensive.” Then he must’ve looked at his own stock for a second time and realized that even though it isn’t as cheap as it was in the past, it’s actually a lot cheaper than many of the other companies on the market today.

This is why Buffett decided to up his spending limit and agreed to buy his own stock for 1.2 times book value, instead of paying about twice that for other companies that were not as good.

Is there any meaning to this move for other stock market investors?

It’s safe to say that you shouldn’t accuse Warren Buffett of dumb luck on his road to becoming a billionaire. And he obviously doesn’t make any stupid decisions by paying more for a business that it’s actually worth.

Here’s a really important question that you need to ask yourself as an investor: since Warren Buffett took a look at the stock market and couldn’t find anything to purchase that’s cheaper than his own company Berkshire Hathaway, and he actually is willing to pay more for his own stock that he was originally willing to pay, what does this mean for you as an investor?

To put it bluntly, it means you should seriously think twice about spending your money on companies in an overpriced stock market as well.

There was a bizarre exchange between Jack Welch and Warren Buffett when they were on CBC together on a recent Monday morning episode. During the interview, the Oracle of Omaha praised Jack Welch’s incredible ability for selling purple shoes.

Don’t worry, because the mystery is solved for everybody now. Well, sort of…

Warren Buffett sent a short e-mail to CNN Money on Tuesday afternoon, late in the day. Within the e-mail, he explains that Welch was “one helluva shoe salesman” back in the day when he worked at Thom McAn.

The CEO of Berkshire Hathaway told us that Welch, the former CEO of General Electric, was particularly good at selling shoes of “the purple variety.” The only problem is that we need Welch to explain this further, or we’re never going to truly get the punch line of this supposed inside joke.

Here’s a quick glimpse at the e-mail in its entirety…

Jack Welch and I are both good friends of Frank Rooney, Chairman of H. H. Brown.  Frank had his 90th birthday about a year ago and Jack told a story about how he started at a Thom McAn shoe store.  He had everybody roaring with laughter as he described how he sold the shoes with the highest commission.  Jack did not realize I was referencing that story when I called in on the phone – I’m sure my call hit him by surprise.  Jack called me after the show as he then realized what I had been referencing.  It’s too bad Jack didn’t get a chance to tell the story on CNBC, as he would have had everybody rolling in the aisles. He was one helluva shoe salesman (particularly the purple variety).

Warren Buffett

Many of the financial talking heads have been telling us that the housing sector has finally bottomed out and it’s going to turn around really soon. Robert Toll, the CEO of Toll Brothers, which is a major homebuilder, claimed that “we may be seeing the floor” back in December. Do you know which year he said that? 2006!

Warren Buffett also called the bottom of the housing market too early, which he mentioned during his 2011 letter to shareholders. He told them that he was dead wrong in his prediction.

But that doesn’t mean that Warren Buffett isn’t grinning today. Wednesday’s economic data showed us that the housing bottom is more than just right around the corner. It has actually already passed us by, and that’s obviously a good thing.

The Census Bureau in the United States of America announced this past Wednesday that the number of new homes being constructed in the United States are their highest since July of 2008. We began construction on 872,000 in September of 2012. This is a 15 percent increase since August, and it’s also a 35 percent increase from this time last year. Economists only expected to see an average of 768,000 homes being built, and that would’ve been only a modest increase.

The big jump in home starts follows a revision in August numbers, which obviously moved upwards, and a host of reports from the National Association of Homebuilders, which showed us that this sentiment has changed in the residential construction industry. Plus, the Schiller-Case home price index shows us that home prices are currently strengthening.

The Census Bureau also released further information on Wednesday, when they shared their estimate of the number of building permits that were granted in September. This is a strong indicator of home starts that will be taking place in the future. They actually granted 894,000 new permits, and this is an 11.6% gain. This shows us that the new housing pipeline is strong enough to continue with the recovery. If you look at the Federal Reserve’s commitment to keep interest rates low on mortgages, combined with six years of growth in the population bumping up against the existing home inventories, the drivers of demand seem to truly be in place to finally overcome the housing market headwinds.

Larry Sorsby, CFO of Hovnanian Enterprises said this past Wednesday: “it’s no longer a question of whether the industry is rebounding. There is clear evidence that we have bounced off the bottom and are in the midst of a recovery.”

Because of this incredible news, the capital goods sector made some of its biggest gains in a while. Hovnanian led the pack, and they reached their 52 week high this past Wednesday, and they are now trading at $4.12 cents per share. The high during the trading day was $4.19. KB Home gained eight point seven percent and Toll Brothers and added another one point eight percent to their share price.

The housing recovery is going to positively affect much more than just a homebuilders. It’s important because the new home starts are a significant indicator of economic growth. Plus, when a family purchases a home, they are going to have to buy all different types of products and services in order to fix it up the way that they like it. So companies like ADT, General Electric and Waste Management tend to benefit from a recovery in the housing market as well.

Another company ready to benefit from new home construction is Caterpillar. They are the largest retailer of heavy equipment for construction all around the world. Caterpillar has a wide variety of material haulers and earth movers, and they have more than any other company in this industry. Plus, they have a wide array of dealers which will expose their products to the homebuilders all around the country. Caterpillar is structured to be a profitable company even during a recession, but a recovery in the housing market is definitely going to boost their sales and allow their profits to soar.

The one person (and company) that has more riding on the recovery of the housing market than any other investor is Warren Buffett. Not only is his capital on the line, but his reputation is on the line as well. He made a big bet in the housing recovery during 2011, and it appeared to be a little bit too soon. But you know Warren Buffett. He doesn’t show any fear, so he doubled down on his housing bets during the past months, and he even bought a wide portfolio of home mortgages. This proves that he truly believes that single-family homes are the best investment available. Also, Berkshire Hathaway recently bought up companies like Clayton Homes, Acme Building Brands and Benjamin Moore. This proves that they are committed to believing in the housing recovery.

These aren’t the only housing recovery bets that Warren Buffett and company have going right now. They have investments in utilities, property reinsurance, home furnishings and mortgage holders. They have subsidiaries in many of these businesses, and there isn’t another company around that has such a broad exposure to the overall turnaround in the housing market. It’s not always easy to understand all of the subsidiaries of Berkshire Hathaway. But there is information and reports on the Internet that can help you do just that.