Saturday 25 February 2017 3:23 pm

Warren Buffett’s annual letter: Star-spangled banners, Gekko, buybacks and insurers

It's great being right. It's even better when being right makes you bucket loads of money. And for around half a century, Warren Buffett – the world's second wealthiest man – has made a name for himself in being both.

Today he sent his annual letter to investors of his behemoth Berkshire Hathaway fund, offering a few titbits of information into how 86-year-old does what he does best. Here are five nuggets you need to know.

1 – He loves the US of A

"One word sums up our country’s achievements: miraculous," said Buffett.

From a standing start 240 years ago – a span of time less than triple my days on earth – Americans have combined human ingenuity, a market system, a tide of talented and ambitious immigrants, and the rule of law to deliver abundance beyond any dreams of our forefathers.

2 – Watch out for Gordon Gekko

Despite doing what he does with Berkshire Hathaway, Buffett has been a long-time advocate for low-cost index tracking funds.

He even put his money where his mouth is in 2007 by betting the founder of hedge fund Protege Partners $1m that Vanguard's S&P 500 stock index fund would beat the returns of a group of several hedge funds over a 10 year period.

Buffett remained confident he'd win the bet at the end of the year. He said the the index fund is up 85.4 percent while the hedge funds are up between 2.9 per cent and 62.8 per cent.

Buffett said: "When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients.

"I’m certain that in almost all cases the managers at both levels were honest and intelligent people. But the results for their investors were dismal – really dismal.

And, alas, the huge fixed fees charged by all of the funds and funds-of-funds involved – fees that were totally unwarranted by performance – were such that their managers were showered with compensation over the nine years that have passed.

As Gordon Gekko might have put it: “Fees never sleep.”

3 – Executives! Be wary of share buybacks

When firms find themselves flush with cash, sometimes boards can be keen to buy back shares for a number of reasons: for example returning value to shareholders or reducing the attractiveness of the business as a takeover target from elsewhere.

But, warned Buffett: "It is important to remember that there are two occasions in which repurchases should not take place, even if the company’s shares are underpriced.

"One is when a business both needs all its available money to protect or expand its own operations and is also uncomfortable adding further debt. Here, the internal need for funds should take priority. This exception assumes, of course, that the business has a decent future awaiting it after the needed expenditures are made.

"The second exception, less common, materialises when a business acquisition (or some other investment opportunity) offers far greater value than do the undervalued shares of the potential repurchaser.

My suggestion: Before even discussing repurchases, a chief exec and his or her board should stand, join hands and in unison declare, “What is smart at one price is stupid at another.”

4 – Berkshire does 'arf love insurers

Why? Well it's simple really. He said: "Insurers receive premiums upfront and pay claims later."

In extreme cases, such as claims arising from exposure to asbestos, payments can stretch over many decades. This collect-now, pay-later model leaves property and casualty [insurance] companies holding large sums – money we call “float” – that will eventually go to others.

"Meanwhile, insurers get to invest this float for their own benefit. Though individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume. Consequently, as our business grows, so does our float.

5 – It's not about him. It's the team

Buffett really likes his team. Lots and lots and lots.

I’m a lucky guy, very fortunate in being surrounded by this excellent staff, a team of highly-talented operating managers and a boardroom of very wise and experienced directors.