Buffett and the Forever Fund

Imagine for a moment that you were approached by a very wealthy foundation, and they asked you to invest their money. They offer a low asset-based fee, but the assets are so large that it looks like a dream to you. Then they tell you the conditions:

• We want this fund to last forever.
• It must be able to deliver cash proceeds of 5% of assets each year.
• We want it to generate a return that exceeds 7%/year over the long haul.
• It must be able to do this through all environments, regardless of war, including civil war, socialism, famine, plague, etc. This is the “forever fund.”
• And if inflation becomes rampant, over 5% / year, you need to earn the inflation rate plus 2% at minimum.

You gulp, and say, “But sir, that’s impossible. The need for current cash is at odds with a forever mandate. Investing to earn the greater of 7% or 2% more than inflation is an unattainable goal. Who can predict inflation? Away from that, the record of investors during times of extreme societal stress is bad at best.”

He says, “Take it or leave it. Those are the goals.”

You ask for a day to think about it, which he grants. You sit back and think, “How can one assure wealth over generations? I can’t prevent wars, plagues or famines. I can’t even prevent domestic political change. What do I do?”

Then it strikes you. Divide the portfolio in two; one part is there for income and to provide liquidity, the other part is there to provide long-term gains. Since the time horizon is very long term, aim for investments where the sustainable competitive advantage is high, and if possible, where a lot of money can be put to work.

Satisfied, you go to sleep, happy that the problem is solved, but as you dream, Warren Buffett stands in front of you as you accept the management contract. When you wake up, you go sign the deal with the endowment sponsor, but wonder about Buffett. You conclude that it was a bad burger you ate at the Dairy Queen the night before, and let the matter drop.

* * *

I thought about writing a negative article regarding Buffett’s purchase of Burlington Northern, but delayed doing it. I di not jump on the idea, partly out respect for Buffett. I have been both an admirer and critic over the years, so I like to think I am even handed here. Why should I criticize? High valuation paid. The free cash flow yield is low.

But Burlington Northern is very hard to replicate. What would it cost to replicate their transport system? A lot, and in this day of environmentalism, it might be impossible to replicate at any price. Thus for one with the “forever fund” such an investment makes sense. Personally, I would have bought utilities contiguous to my existing holdings, because the same conditions exist there. Steady income plus inflation protection.

So, I don’t fault Buffett for buying Burlington Northern (BNI). It makes sense with a very long term view. There might have been better buys among utilities, but he has a lot of money to put to work. He may mop up the utilities next year. Or a cheap large energy company — oh, whoops, he sold that.

When you have a lot of money, the choices get tough. The simple decision is to index, but you didn’t get a lot of money through indexing, so you want to do better. At present, my view would be to buy utility shares and high quality stocks, which have not rallied much, and have defensive characteristics should the market fall. In other eras, real estate might be the investment… but not now.

These companies provide value regardless of the economic circumstances; they are valuable even in bad times. In really bad times, nothing is valuable.

Comments

[John Galt:]

One train can do the job and take 280 trucks off the road. It's cleaner, cheaper, and economies of scale. Buffet says there will be more Americans in 10, 20 and 30 years.

BNI operates on the West coast & the Mid West
West Coast = growth, more business with Asia in the future
Mid West = commodities, coal, grains, wheat

Right now we are in a recession/depression
Recession = less goods moved
At some point in the future we won't be.

Higher population = more goods needing to be moved
Train = 280 trucks off the road
Train = less fuel

Do you think gas prices will be lower or higher in 10, 20, or 30 years?

How about the trucking unions? Will they ask for more or less money in the future?

Railroads have less workers today than a decade ago. There have been major advances in the business. Don't forget that railroads were the "safe investments" years ago, but nobody thinks about them today.

Long BNI

Nov 13 09:24 AM

[a fat panda:]

The interesting part of the purchase is how he paid for it because paying in stock is a departure from the past.

The last time I recall him doing it was the purchase of a re-insurer in the late 90s. It may have been 99. The assets he traded were things like Coke at 40 times earnings for a company that largely held debt, and unforunately some deriviatives. All told swaping Coke at 40 times earning for debt was a pretty good deal.

I am not sure that Buffett looks at deals in dollar terms because what you can sell them for is irrelevant if you WILL NOT SELL THEM. When he looks at purchases with stock he is looking at the assets that he gives-up and the assets he gets.

Nov 13 09:38 AM

[value inves...:]

don't have to worry about chinese or japanese putting down tracks next to BNSF's... this is a multi-lifetime asset that can't be replicated... moats don't get any bigger than this... with respect to utilities, they are highly regulated (rails are semi-regulated... a lot of BNSF's business is unregulated).

Nov 13 10:03 AM

[Dave Shafer:]

It's really pretty simple. Buffett saw a well managed business, still throwing off cash flow in a recession, with a huge moat, and a huge upside if trends continue. You may disagree with the upside potential, although Buffett has been much more right than you about these things.
He traded cash and a little debt for which he ultimately gets for free from the float for a large cash flowing asset.

Nov 13 10:07 AM

[value inves...:]

an accounting change (as a result of the acquistion of BNSF) should lead to better pricing power. when BNSF is acquired, BRK will mark up the assets (using purchase accounting). assets on the books of BNSF are substantially undervalued (a bridge might be on the books for $30,000, but would cost $10 million to replace... as an example). after the marking-up of assets, BNSF's return on capital will fall. the STB (surface transportation board), in my opinion, will have to switch from GAAP accounting to replacement accounting when calculating the regulatory return on capital... this is used to determine if a railroad is "revenue adequate". i think the STB will discover that the returns on replacement value are low... and that will allow for more pricing power... just a theory, but i think this will happen.

Nov 13 10:17 AM

[Rong:]

Often reference is made to the fact that the RRs have fewer employees than before. They now hire private contractors, to do many jobs that were previously done by their own employees. Large construction equipment owned by the RRs and by the contractors does the work that earlier required several people to accomplish. The large equipment; does not suffer personal injury and the costs of employee benefits furnished by the contractors, such as retirement and unemployment are not as burdensome. Fewer people now but the work does get done. Check the track record.

Nov 13 11:29 AM

[Hester:]

Great buy by Buffet, imo. For all the reasons previously mentioned plus, BNI's hard assets are a great hedge against inflation. Also, the more inflation the better for railroads, because more inflation means higher oil prices. That means railroads will become the preferred mode of transportation for America's goods. Buffet has said he is worried about future hyper inflation. I think that might of attributed to his decision to buy a railroad. With or without future hyperinflation, I think this is a great long term purchase.

Long Railroads.

Nov 13 11:47 AM

[mbkelly75:]

Warren Buffet is one of my heroes - even if we are the same generation. He makes very few mistakes and I doubt the long term will show that BNI was one of the few. BTW - your forever fund can be reached by focusing on dividend-paying stocks with a 5 year or longer record of RAISING those dividends. I know that it can be done as I am handling investments for a third generation now for my family.

Nov 13 12:07 PM

[Graham and ...:]

Tell me someone's strategic imperatives, and I can (usually) forecast his actions.

Nov 13 07:37 PM

[jimmy46:]

With oil going higher, Buffet sees the future.

The future is rail. For both freight and people.

Just yesterday the country of Qatar inked a mega billion euro deal for a rail network to be built there.

They see what Buffet sees.

Nov 23 04:16 PM