Markets finish week down after bouncing on Bannon's exit >>> READ MORE

Warren Buffett’s Letter: Valuable Lessons From the Oracle

Buffett sounds off on buybacks, dilution and cheap index funds

    View All  

Warren Buffett published his annual letter to investors this past weekend, and when Buffett speaks, the rest of us mere mortals sit up and listen. At 86 years old, Mr. Buffett has a lifetime of insight to share. And seeing as how he won’t be with us forever, his letters get more and more valuable with each passing year.

Warren Buffett's Letter: Valuable Lessons From the Oracle
Source: Grab Media

So today, let’s go through the Oracle of Omaha’s letter to look for nuggets of wisdom.

Buffett started with a fair amount of self congratulation, but in fairness, I’d say it was deserved. After all, Berkshire Hathaway Inc. (NYSE:BRK.A, NYSE:BRK.B) shares are up almost 2 million percent since Buffett took the reins in 1964. Not a bad run.

But there were definitely some bumps in the road and some painful lessons learned, which brings me to Buffett’s first memorable quote about stock-funded mergers:

“Today, I would rather prep for a colonoscopy than issue Berkshire shares.”

Buffett recounted an incident back in 1998 in which he diluted his shareholders by 22% issuing new Berkshire stock to buy Swiss Re. While Swiss Re has been a solid holding for Buffett, the returns never quite justified the 22% dilution and Berkshire shareholders ending up giving “far more than they received.”

Think about it. Buffett effectively traded 22% of Berkshire Hathaway — one of the greatest wealth generators of all time — for a run-of-the-mill insurance company. That’s a bad trade. And likewise, investors would be wise to avoid companies that habitually use their stock like currency for acquisitions. If a stock is worth owning, you don’t want management trading it for something inferior.

On Share Repurchases

Of course, the opposite of issuing new shares is buying back existing shares via buybacks. And Buffett has quite a bit to say on that matter as well. While repurchases are a perfectly reasonable way to allocate capital not needed for new projects …

“Repurchases only make sense if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value. Consider a simple analogy: If there are three equal partners in a business worth $3,000 and one is bought out by the partnership for $900, each of the remaining partners realizes an immediate gain of $50. If the exiting partner is paid $1,100, however, the continuing partners each suffer a loss of $50. The same math applies with corporations and their shareholders. Ergo, the question of whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent.”

Buffett points out that, while this should be obvious, company boards of directors usually seem “oblivious to price.” Buffett himself has a hard cap on repurchases of Berkshire Hathaway shares. He’ll only consider a buyback if shares are trading for less than 120% of book value — a level Buffett and his board consider to be safely below the company’s intrinsic value.

For investors, the takeaway is clear: Look for disciplined companies that use buybacks to add value when their shares are underpriced. Because “what is smart at one price is stupid at another.”

On Indexing

As perhaps the most successful active manager in history, it’s more than a little ironic that Warren Buffett has become a vocal supporter of low-cost indexing. In fact, Buffett has repeatedly said that most investors would be best served by buying a simple S&P 500 index fund and letting it compound for decades.

Buffett then goes on bash hedge funds, estimating that wealthy and institutional investors have wasted over $100 billion over the past decade, mostly due to high fees. This particular quote has gotten a lot of press and added to Buffett’s mystique as an anti-Wall-Street hero.

Next Page


Article printed from InvestorPlace Media, http://investorplace.com/2017/02/warren-buffett-letter-valuable-lessons-from-the-oracle/.

©2017 InvestorPlace Media, LLC