Berkshire Hathaway, Warren Buffet’s investment vehicle announced today it would take 100% control of one of the nation’s largest railways, Burlington Northern Santa Fe (BNI).Trusted Financial holds, in most client portfolios, a position in Berkshire Hathaway, and this commentator has personally held a position in the company for some 12 years. Today’s acquisition, Berkshire’s largest is not something I applaud, but it is revealing when one considers the evolution of investment style of the greatest investor of our Age. As a child in Omaha, Nebraska, Warren Buffet commented to a friend who lived on a busy thoroughfare, that he wished they could find a way to erect a toll booth and collect money for every car that passed. Buffet’s desire to own businesses that have an effective monopoly, like a toll bridge, has been chronicled in books like Roger Lowenstein’s “Warren Buffet, the Making of an American Capitalist“, a 1995 work that I am in the midst of re-reading. Earlier this year I read the massive “The Snowball” (Alice Schroeder,(C) 2008, Bantam Books). From what I’ve learned of this focused capitalist, I’m not surprised by today’s announcement, but as one who tends to subscribe to a purer form of Graham-Dodd value investing, the choice worries me.
Berkshire, the company that Buffet controls, has been sitting on over $30BB of cash, and due to its massive size, has limited investment options (small purchases can’t move the needle, they must buy Big). Railroads fit the “toll bridge’ model. As Morningstar commented in a March, 2009 analysis of BNI: “North American railroads own assets that are practically impossible to replicate. The challenge of obtaining rights-of-way and the cost of building track erect insurmountable barriers to entry. Despite this powerful advantage, railroads have historically failed to earn returns on investment greater than their cost of capital. However, Burlington Northern Santa Fe has generated returns on equity averaging 18% during the past three years and produced average free cash flow of more than 7% of revenue for a decade. Because of its established network, we believe BNSF has a narrow economic moat protecting its profitability from competitors. ” Further, the company derives nearly 1/3 of its revenue from shipping coal, much of it “clean coal” from Wyoming. This promises to be a growth industry, and parellels Berkshire’s 2002 purchase of MidAmerican, which derives 1/3 of its revenue from acting as natural gas pipeline. Intentionallyl, our clients’ largest equity holdings are devoted to gas pipelines, and similar monopolistic utility companies because, like railways, they are “toll bridges”.
Alerted by Berkshire’s interest in BNI (they owned 22% of the company prior to today’s announcement) I sniffed around the publicly held railroads earlier this year, but could not convince myself that they were trading at sufficient discounts to intrinsic value to merit our interest. That was probably unfortunate. With today’s announcement, all railroad stocks will undoubtedly rise in value, so its probably too late to find a bargain there. Still,it appears to me that Buffet may have overpaid for this purchase, a 33% premium to the market price at yesterday’s close, and above estimated intrinsic value. This is a capital intensive industry, of the kind Buffet avoided in his earlier days. It is also unionized and suffers from a good deal of government regulation. I wonder if the sheer size of his operation has condemned Buffet to overpaying for businesses from here out. As early as the 1960’s Buffet began using measures other than intrinsic value to choose investments, most notably the character of management. One cannot dispute the sucess of his judgment, particularly in the years prior to 2000. However, Buffet’s evolution away form traditional Graham-Dodd value investing has resulted in some mistakes, notably General Re, which turned into a snake pit, and Clayton Homes, a good company in a declining industry, that has been decimated by the housing collapse and tight money. While I understand the toll bridge nature of a rail operation and no doubt Mr. Buffet is impressed with BNI ‘s management, (this is one of the only railroads that has been able to earn high returns on equity), this purchase worries me. As Berkshire shareholders, we look forward to watching as, under Buffet’s direction, the company squeezes even better returns out of its operations, otherwise, it may be a long time until this investment can be justified.
