Has Buffett Lost His Mind?

In the article Berkshire + Burlington, I argued that Berkshire's (BRK.A) purchase of Burlington (BNI) was out of character and had little to do with value. It also seems clear that Burlington will raise Berkshire's risk profile. Some people took offense on the assumption that Buffett can do no wrong.

Sadly, I'm old enough to remember Berkshire's US Airways and Solomon investments. NetJets has been a money pit, and let's not talk about GeneralRe. Nonetheless, I count myself among the legions of Buffett fans. Still admiration can turn to idol worship if we can't acknowledge that Buffett is human, and thus subject to error.

In a Charlie Rose interview, Buffett said BNI's results over the "next 100 years" would justify the purchase price! How's that for a payback period? He also said that it was an "all-in bet" and furthermore that Burlington was "not a bargain". Personally, I preferred the Goldman (GS) and General Electric (GE) investments. We didn't have to wait 100 years for those to prove their worth.

As for Burlington, I rest my case. But if Buffett's own words aren't enough, Columbia professor Bruce Greenwald, value investor and author of "Value Investing: From Graham to Buffett and Beyond", went one step further.

In a recent interview, he was asked:

You own Berkshire Hathaway, so (what do) you think about Buffett’s purchase of Burlington Northern?

Greenwald's response:

It’s a crazy deal. It’s an insane deal. We looked at Burlington Northern at $75 and I’ll give you the exact calculation we did. You don’t have a high earnings return. They are paying 18 times earnings, but it’s really much worse than that. They report maintenance cap-ex very carefully. They report depreciation and amortization, and they report only about 70% of the maintenance cap-ex. So they are under-depreciating, and their profit numbers are lower than the true profit numbers – and in a bad way, because the tax shield for the depreciation is undergone too. Their profitability is much lower than it looks.

Buffett’s paying 18-times [at $100/share] and at $75 he was paying 16-times. Our calculation is he was paying 21-times.

Secondly, there are two kinds of assets. There are the rights-of-way, which you can’t get rid of. So there’s no issue about having to earn a return on them because you have to keep it in the business, and because there’s nothing they can do with those rights-of-way. If you look at the asset value of the non-right-of-way equipment, and you write it up because it’s more expensive than it was originally, you get an asset value that’s very close to the earnings power value. We didn’t see a lot franchise value or hidden asset value.

The other thing is that if you try to calculate sustainable earnings, you have to cope with the fact that earnings are up enormously since 2003, when oil went up. There is a simple calculation you can do, which compares the cost-per-ton-mile for freight for a truck versus a railroad. If you build the increase in the price of diesel fuel into the post-2003 experience, when revenues suddenly start to grow, what you see is that the entire growth of the revenue is accounted for by the energy advantage that the railroads have and therefore how much business they can capture from the truckers, and how much pricing they can get because the competition is now more expensive.

There is nothing special about the railroads. It’s entirely an energy play.

If you look at what their margins should have gone up by, given the energy efficiency, the margins go up by only about half of that. So you don’t have a good aggressive management over these five years producing outsized returns.

We looked back at when they did the merger with Santa Fe, because then they did increase margins. But they got bored with it, and margins started to come down. The same thing happened recently. We don’t see a lot of hidden profitability in the culture of the company.

It looked to us like an oil play. He has a history of making bad oil play decisions. And that was at $75/share, we thought there were better oil plays. At $100/share we think he has lost his mind.

A crazy, insanely bad decision.

Don't hold back, Bruce.

Author's Disclosure: No positions.

Comments

[gambitrader]

I believe Warren Buffet is very strategic. Through my research I have come to one conclusion - Mr Buffet is diversifying his massive USD holdings. If the feds reflation efforts succeed, the USD will be worth less than now, and oil will be much higher. Both elements explain his recent actions in markets. A higher oil price will benefit rail freight, and a lower USD will inflate all assets in the future.

2009 Nov 23 06:03 AM

[Brad Ferris]

I think its a simple situation of Buffett realizing the worth of a well run company and having little problem overpaying (by today's standards) for future earnings that will be much higher than today's. He has shown this ability time & time again because he rationalizes his purchases different than most investors. BNI is a very good company, but don't except 30% returns for the next 10 years; it's not that type of company. What it will offer is a very good operating foundation for BRK to diversify out of so much insurance and consumer products companies. Essentially someone has to ship all that Coke, Kraft Dinner and JNJ Baby Shampoo :)

2009 Nov 23 06:50 AM

[Davewmart]

Check out oil prices now, in the depth of a recession.
What will happen to them at the first hint of recovery?

2009 Nov 23 06:57 AM

[Mark Rosner]

It's more than just an energy play. If you look at the spreads between truck and rail pricing, it has historically been 10 to 20 percent. Fuel cost is a very large component but there are other factors that have driven up trucking costs such as emissions regulations that have made newer trucks less fuel efficient (I've heard up to 8% less than a decade ago), rising insurance costs, highway congestion and up until recently wage inflation for truck drivers (caused by supply/demand). A few years ago, a study commissioned by the ATA predicted that a driver shortage was imminent and that median driver wages would go from about $45k to $75k. Freight volumes have collapsed with the economic downturn and that has improved the supply of drivers. If you couple that with the theory that when construction is booming many drivers switch to construction (or driving trucks for construction) then you can see how the driver shortage has completely disappeared. Ultimately though, it is congestion that makes rail a great investment and congestion comes in two forms. First there is rail congestion which has resulted from the rail companies streamlining their (merged) networks over the past few decades. This has caused capacity issues and has allowed rail to price more for their service. The other (and much larger) form of congestion is road congestion which will continue to increase in severity in North America as population continues to grow. As road congestion increases, trucking costs will continue to rise faster than inflation (thus rail will be able to ride the pricing spread up). Think about how much being stuck in traffic for an additional two hours per day will effect trucking. In addition to more labor, trucking companies will need to invest in more trucks to do the same task. These additional trucks consume more than just capital dollars. They also increase opex spend through additional insurance and maintenance costs. So bottom line, I think rail is a long term play due to congestion...but it's a real long term play and that's where I think Buffet got it right.

2009 Nov 23 07:42 AM

[Davewmart]

Mark Rosner,
What fuel do you imagine that this greatly increased fleet of cars is going to be putting in their tanks?
Because it sure ain't going to be petrol! - unless the Chinese suddenly decide that they don't fancy driving cars after all.

2009 Nov 23 08:01 AM

[anonymiser]

I am very glad that I bought BNI when it was in the low 20s. The dividends are a lot better than what I could get in a bank, the investment is pretty safe, and I can sell for a profit any time I want.

2009 Nov 23 08:32 AM

[delbertino]

Buffett's Moody's/Insurance play got me wary; and his forex record put him on my level; he are smart, but disobeys his own strictures from time to time; jus' sayin';

2009 Nov 23 08:36 AM

[long_on_oil]

Justifying a purchase you want is easy, it's human nature. Have you ever purchased a new car? There is no justification of buying a new car over a good used one when it comes to costs but we do it anyway. We enjoy eating depreciation expense.
I am a long time owner of BRK and the purchase of BNI is not upsetting to me. What upsets me is that BRK can't keep up with the market during this latest recovery and Buffet refuses to pay a dividend. He once said that if he could not find a way to make a decent return on cash then he would start paying dividends and let the stockholders try their hand. Well, IMO that time has come.

2009 Nov 23 08:38 AM

[Ravi Nagarajan]

Calling the deal "crazy" or "insane" does little to add to the discussion in my opinion. These are merely emotionally loaded terms. To get a sense for whether this deal makes sense, one only needs to listen to what Buffett has actually said:

(1) He is not claiming that this is a home run and has acknowledged that returns will be similar in size to what can be expected from utility type investments.

(2) He is not claiming that BNI is "cheap" although Buffett has a history of being diplomatic when it comes to doing deals. It would hardly help the deal go through to go around boasting about getting a good price.

(3) Berkshire's operating companies have large amounts of free cash flow that cannot be reinvested in the operating companies generating that cash flow at acceptable returns. Therefore, the cash comes to Omaha for redeployment. For the last several years, that cash has just piled up. Last October, some of it was put to good use opportunistically (GS, GE, etc). However, Berkshire needs a long term dependable place to reinvest cash flow and the railroads seem to be a good solution for the "problem" of all this cash coming into Omaha.

Of course, the other options for deploying free cash flow include dividends, share buybacks, and buying private companies. I don't think BNI precludes any of these additional options from being pursued.

Shareholders who have realistic expectations for Berkshire (that is, increases in intrinsic value exceeding the S&P 500 by a few points/year) are not the ones who are disappointed. The critics are mainly upset that Buffett has settled for something unlikely to deliver a home run. But that's not what he's trying to do at this stage.

2009 Nov 23 08:48 AM

[DownOnMyLuck]

You mis-characterize what Buffet said. He said the results over the next 100 years would justify the purchase price, not that the payback period is 100 years.

2009 Nov 23 09:09 AM

[Duude]

I was bewildered when he paid the premium he paid. Its not whether Berkshire will make a reasonable return on investment but how much and in what time frame? If the economy remains sluggish for the next few years, and if the current power in Washington keeps denying new coal mining permits while succeeding in passing a cap and trade bill, we can be assured a reasonable return won't happen in Buffet's life time. This all goes back to the time value of money. Is this the best strategy for Berkshire resources? I vote doubtful.

2009 Nov 23 09:24 AM

[OstrichHater]

I think Greenwald has it right. BNI is an energy play. But I think it is also an inflation play. The US Govt keeps printing money and the value of it will drop, forcing up the price of oil which is priced in dollars. Of course the printing of money will also boost the economy, which will doubly drive up the price of oil.

Bruce Greenwald is one of the smartest guys out there. If you dont know who he is, you should look into it, because he has an intelligence that is comparable to Buffet's.

2009 Nov 23 09:26 AM

[maz]

Duude,

Cap & Trade would benefit BNI far more than its likely loss of coal traffic - which in any case would not be disastrous - you can't switch electricity generating coal power plants overnight and they are around 50% of total.

OTOH cap & trade puts rail at enormous advantages over trucks so bring it on I say

Long term this looks good but I reckon Greenwald is right in the next 5 or even 10 years - BNI will not improve Berkshire's results much (except you could say that earning a pittance on billions in cash is a poor alternative) & you'd have to adjust Berkshire's valuation downward if that's all you considered. But this is still a long term triple play imo

1. Oil prices go up long term because of excess demand over supply - regardless of currency
2. Oil prices go up as the US$ devalues because they are quoted in US$.
3. Rail stands to benefit from any cap & trade or other climate change legislation.

#3 might end up being the biggest benefit. In Europe rail is used on much shorter distances than in the US because of much higher (2x) gas prices, congestion and a much stronger environmental lobby & we can expect these trends to eventually hit the US imo

So I'd agree short term he's outta his mind but long term he's got it right & the trouble is that investors don't want to look one year ahead never mind 10 :-)

2009 Nov 23 11:21 AM

[Dan Braem]

I wrote an article on this deal...why does no one even discuss the advantages of owning the entire company?

Not only does he get a 20% tax advantage to buying the entire company (on all repatriation of profits), he gets to determine how much he can pull out of BNI. After 40+ years of doing deals, you think most investors would realize Buffett prefers owning entire companies, and for good reason.

BNI was not a bargain or a value purchase - everyone knows that. But it is time to look at the big picture. BRK is a big conglomerate, and this is a big conglomerate purchase.

The real surprise to me is that Buffett didn't buy something big in March 2009. Perhaps it was his belief that the financing wouldn't be available.

2009 Nov 23 11:51 AM

[The Lonely Value Investor]

A railroad could earn a 30% return for its owners if the purchase price were low enough. Railroads in general and BNI specifically are not inherently good investments. The price Buffett paid basically assures that it won't be.

Buffett has a huge operating foundation which was built on strong cash flows and reasonable valuations. Why does that need to be diversified???

And Coca-Cola, Kraft Dinner and JNJ Baby Shampoo typically are shipped by truck, not rail. It's coal, coal, coal, and more coal.


On Nov 23 06:50 AM Brad Ferris wrote:

> I think its a simple situation of Buffett realizing the worth of
> a well run company and having little problem overpaying (by today's
> standards) for future earnings that will be much higher than today's.
> He has shown this ability time & time again because he rationalizes
> his purchases different than most investors. BNI is a very good
> company, but don't except 30% returns for the next 10 years; it's
> not that type of company. What it will offer is a very good operating
> foundation for BRK to diversify out of so much insurance and consumer
> products companies. Essentially someone has to ship all that Coke,
> Kraft Dinner and JNJ Baby Shampoo :)

2009 Nov 23 11:55 AM

[The Lonely Value Investor]

Mark Rosner needs to read what Greenwald said. He proves there is little sustainable competitive advantage between truck and rail.

BNI will probably be a better investment than cash over the next 100 years, but that isn't the argument. The BNI critics are not arguing for holding cash indefinitely. There are many other alternatives.

Why not buy (or increase) 5 smaller rail stakes in the open market and avoid paying the ridiculous premium?

2009 Nov 23 12:01 PM

[Benny D.]

I would be a buyer if BRK.B paid a dividend.

2009 Nov 23 01:00 PM

[Advill]

The premises for investment of Mr. Buffet and "Charlie" are not the regular goals of common investors, they are planning for 100 years which is not the average goal.

The risk he is running is that something new can arrive to move goods instead the rail, and it seems highly improbable right now, the other risk is bad management or government confiscation which are improbable right now.
What is cheap or not in 100 years investment horizon?


On Nov 23 08:48 AM Ravi Nagarajan wrote:

> Calling the deal "crazy" or "insane" does little to add to the discussion
> in my opinion. These are merely emotionally loaded terms. To get
> a sense for whether this deal makes sense, one only needs to listen
> to what Buffett has actually said:
>
> (1) He is not claiming that this is a home run and has acknowledged
> that returns will be similar in size to what can be expected from
> utility type investments.
>
> (2) He is not claiming that BNI is "cheap" although Buffett has a
> history of being diplomatic when it comes to doing deals. It would
> hardly help the deal go through to go around boasting about getting
> a good price.
>
> (3) Berkshire's operating companies have large amounts of free cash
> flow that cannot be reinvested in the operating companies generating
> that cash flow at acceptable returns. Therefore, the cash comes
> to Omaha for redeployment. For the last several years, that cash
> has just piled up. Last October, some of it was put to good use
> opportunistically (GS, GE, etc). However, Berkshire needs a long
> term dependable place to reinvest cash flow and the railroads seem
> to be a good solution for the "problem" of all this cash coming into
> Omaha.
>
> Of course, the other options for deploying free cash flow include
> dividends, share buybacks, and buying private companies. I don't
> think BNI precludes any of these additional options from being pursued.
>
>
> Shareholders who have realistic expectations for Berkshire (that
> is, increases in intrinsic value exceeding the S&P 500 by a few
> points/year) are not the ones who are disappointed. The critics
> are mainly upset that Buffett has settled for something unlikely
> to deliver a home run. But that's not what he's trying to do at
> this stage.

2009 Nov 23 01:05 PM

[dividend_growth]

Can anyone take $100 billion and replicate BNI?

2009 Nov 23 02:20 PM

[el pescador]

Pure and simple. Buffett is no dummy when it comes to money. There is no competition in the railroad industry and the existing lines could further serve as real estate for future infrastructure for the potential of high speed lines as well as energy. The intrinsic value coupled with the future value will be a win win.

I don't see the lonely value investor up their as one of the wealthiest investors in the world.

2009 Nov 23 02:50 PM