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Warren Buffett's Letter: Valuable Lessons From the Oracle

Charles Sizemore, InvestorPlace.com

Pete Souza via Flickr

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.

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

Prices and data are from the original InvestorPlace story published on February 28, 2017. Click on ticker-symbol links in each slide for current prices and more.

On Share Dilution


Buffett started with a fair amount of self congratulation, but in fairness, I'd say it was deserved. After all, Berkshire Hathaway Inc. (BRK.A, 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.

SEE ALSO FROM KIPLINGER: How Well Do You Really Know Warren Buffett?

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."

SEE ALSO FROM INVESTORPLACE: 7 Ultra-Cheap Value Stocks to Buy Now

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 to 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.

But what is far more interesting is Warren Buffett's caveat that follows:

"Berkshire loves to pay fees -- even outrageous fees -- to investment bankers who bring us acquisitions. Moreover, we have paid substantial sums for over-performance to our two in-house investment managers -- and we hope to make even larger payments to them in the future."

You shouldn't pay high fees to a large-cap growth mutual fund manager. At the end of the day, their performance isn't likely to vary meaningfully from the S&P 500; most mutual fund managers are closet indexers that essentially hug the index.

But if you have a manager that is doing something innovative or hard to replicate elsewhere, you shouldn't begrudge them their fee, even if they are "outrageous."

SEE ALSO FROM KIPLINGER: 11 Dow Stocks Owned by Warren Buffett

The Man Himself


Finally, Buffett spent a good part of the letter praising America's capitalist system and the truly amazing amount of wealth it has created over the years. Buffett is refreshingly optimistic ... which is probably why he's still going strong at 86 years old despite subsisting on a diet of junk food that would kill most men in their 40s.

So perhaps the best advice you can take from the Oracle is to keep a positive attitude and take joy in your work. And perhaps have a Cherry Coke with your lunch.

This article is by Charles Sizemore of InvestorPlace. As of this writing, he held none of the aforementioned securities.

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