[The Editors' Verdict] Buffett's Japan Investment, Son's Call Option Strategy

Kyungsoo Kim, Professor Emeritus at Sungkyunkwan University

Last summer's rally in the global stock market and the subsequent major correction are known to have been influenced by Masayoshi Son, chairman of the Japanese investment group SoftBank, who made massive purchases of call options on giant tech company stocks (worth $4 billion).

The fear of missing out on the stock rally led to investments in call options, which grant the right to buy stocks at a future date, rather than direct stock purchases. Call option investments provide an opportunity to ride the rally without increasing the capital tied up in risky assets. Financial firms that sell call options bear the risk of having to transfer the underlying stocks to the option buyers at the pre-agreed strike price if the options are exercised. This risk is managed by the financial firms purchasing the underlying stocks themselves, engaging in dynamic hedging by buying more stocks when prices rise and the likelihood of exercise increases, and selling stocks when prices fall.

In such a hedging strategy where stocks are bought when prices rise and sold when they fall, a large volume of call options trading can cause stock prices to rise further during rallies and plummet during downturns. This can make it appear as if stock prices are overreacting to minor news.

Although SoftBank's option exposure is enormous (around $50 billion), the total exposure to stocks is estimated to be three times the usual amount (an average daily exposure of $300 billion). Individual investors have been able to easily invest in stock derivatives such as options by installing applications on their smartphones. Moreover, because these options have shorter maturities than those held by institutional investors, stock price volatility has increased.

In the context of the COVID-19 pandemic crisis, where global economic buffers are fragile, a small negative shock can cause widespread economic damage when the tail wags the dog. Individual investors who aggressively buy during market corrections should exercise caution.

At the end of last month, Berkshire Hathaway, led by Warren Buffett, announced an investment of about $6 billion, representing roughly 5% of the total shares, in five Japanese general trading companies. The trading companies Buffett invested in have complex ownership structures with hundreds of subsidiaries and affiliates ranging from convenience stores to energy, automotive, and food companies, and are known to be undervalued due to a high proportion of internal transactions.

Until now, the Japanese stock market had been a forgotten market. From the end of 2012, when Shinzo Abe was elected Prime Minister of Japan and Abenomics began, until the first half of 2015, foreign stock investments exceeded $230 billion, but after the results were exhausted, the funds flowed out like an ebb tide three years later. Investors shunned Japan due to its chronic 3Ds (deflation, demographics, and debt).

In line with being the world's largest asset country, Japanese companies have accumulated massive cash reserves. Cash and deposits held by non-financial companies (around $3 trillion) continue to increase due to a lack of investment demand. Dividend yields (dividends per share relative to stock price) are also higher compared to other developed countries.

In an era led by growth stocks, people mocked 90-year-old Buffett, who pursues value investing throughout his life, after he suffered investment losses exceeding $7 billion in energy and airlines. However, when Buffett's investment news came out amid global stock market turmoil, everyone remained silent. He reminded investors that they need to seek new opportunities.

Buffett first visited Japan in 2011, the year the Fukushima earthquake occurred. One year earlier, Berkshire Hathaway had issued yen-denominated bonds close to $1 billion. This shows how carefully Buffett had planned this investment. Perhaps he even anticipated a future decline in the value of the dollar and aimed to gain foreign exchange profits as a bonus. When the option investment became known, SoftBank's stock price plummeted. Instead, the stock prices of the trading companies Buffett invested in rose by the same proportion that SoftBank's stock fell.

Kyungsoo Kim, Professor Emeritus, Sungkyunkwan University