Why is Warren Buffett So Interested In The Railroad Industry?

Recently, Berkshire Hathaway (NYSE: BRK.A) disclosed its 10.9% stake in Burlington Northern Santa Fe (NYSE: BNI) worth US$3.4 billion. To no one’s surprise, investors around the globe jumped on the Warren Buffett express. Burlington’s share price rose 6.5% on the announcement.

And Buffett didn’t stop there. Berkshire Hathaway confirmed it has also acquired stakes in two remaining North American railroads. The largest American railroads remaining are Union Pacific (NYSE: UNP), CSX (NYSE: CSX) and Norfolk Southern (NYSE: NSC). Our neighbors to the north offer Canadian National [TSE: CNR].

No one really knows why Warren Buffett fell in love with railroad investing all of a sudden. Burlington certainly carries Buffett-like characteristics: consistent earnings growth (22% annualised over five years), impressive margins and limited competition.

But none of these railroads typify your typical Benjamin Graham value play. The stock trades for more than three times book with limited liquidity and tangible debt.

So what was Warren Buffett thinking that drove Berkshire Hathaway onto the rails?

It’s anyone’s guess. But the prevailing consensus believes globalisation - specifically, moving the major staples of trade (things like coal, oil, cars and clothes - in other words, basic commodities and finished goods) from producer to consumer - is the long-term trend at play here.

I’ll buy that.

It was about this time in 2002 that a rebirth in the tangible assets sector really began. Much of that growth can be directly attributed to the insatiable demand for raw materials that the developing giants China and India are now consuming.

These countries are still in the early stages of development. It takes about 30 years to go from an agrarian to an industrial society. China is about one-third of the way there. China will continue to import commodities to sustain this enormous transition. India will do the same.

Furthermore, the golden era of stocks (1982-2000) directed capital in about every investing avenue except natural resources and raw materials. Hence, limited demand caused a decrease in available supply.

Now the entire world can’t get enough copper, zinc, lumber and oil. But bringing on new production takes time. Supply can’t catch up with demand overnight. In fact, it’s going to take quite some time, especially when you throw the consumption potential of India and China (37% of the world’s population) into the mix. Consequently, commodities, the market for the essentials, will remain tight for the foreseeable future.

And commodity consumption won’t be limited to emerging markets alone. Let’s not forget that the United States has begun to embrace alternative energy. And the two greatest oil alternatives, coal and corn, are shipped by train.

So transport stocks like Burlington certainly play into this long-term trend. And considering that rising fuel prices affect trucks more than trains, this idea begins to make more and more sense.

But many feel it’s too late. Many believe the upside is already priced in.

Well, that may be true.

You see, recently, Prudential, Bear Stearns and UBS all downgraded BNI to some type of peer perform/neutral rating. Most investors are now asking: was Buffett wrong?

The key to that last sentence is the word “investors”. Most individuals who buy and sell shares are traders, not investors. These are people looking for a quick buck. The type of action that reflects an attitude more suited for the Las Vegas Strip, not the undying, underappreciated sex appeal attached to the US$500 monthly deposit in the retirement fund.

Without becoming too insipidly philosophical here, let me quickly add this. Blaise Pascal once said: “Most of men’s problems arise from their inability to sit quietly and alone”.

That’s a fair point. Actually, that’s a very good point.

It takes a rare soul to patiently sit on a US$32 billion Korean steel stock when the daily headlines of even the most conservative publications saturate our brains with tales of highflying hedge fund managers making upward of US$1 billion annually or A-list celebrities with nothing more than a high school degree receiving a US$20 million payday.

But take solace in this. As Max Ehrmann wrote: “If you compare yourself with others, you may become vain and bitter; for always there will be greater and lesser persons than yourself. Enjoy your achievements as well as your plans.”

Shipping is, and will remain, irreplaceable on the world stage. We can’t live without it. It won’t be replaced. It’s been around for centuries. Until we reach a stage of technological innovation in which the major staples of trade - things like coal, oil, cars, the finished products that fill Wal-Mart stores - can be disassembled one molecule at a time and instantaneously beamed to another location, our current means for commerce will remain the most efficient.

Comments

[Lee Johnson...:]

You dismiss the relative energy-efficiency of RRs vs. trucks much too blithely. It is not simply another factor. It is THE DRIVING AND DETERMINING FACT. The positive net energy (see the works of Dr. Howard T. Odum, Robert Herendeen, Joel Schatz's energy TRANSITION REPORT for Ore. gov. Tom McCall in 1974, or any energy analyses since the mid-1970's from the Center for Advanced Computation, U. of Ill., Champaign-Urbana) of the new giant diesel units from GE now pulling our 300 car trains is enormous relative to even the aerodynamically designed and shrouded semi-trailer trucks. As world fuel costs rise, goods shipment will increasingly switch to rail world-wide. Trucks will be net losers and fall back to a local delivery role from the railyards of the world. Buffett, and his small staff, are just early in recognizing this, and the current continuing great under-valuing of RRs, here and abroad. This under-valuing, as you have done, comes from energy naive analysts who do not understand either net energy theory and its applications, or the fact that we are at or near the plateau of Peak Oil. There is no doubt Buffett uses net energy in his investment evaluations. Note that he has made no investments in the super-hyped corn/sugar/cellulosic ethanol or biodiesel craze despite his being in the Midwest hotbed of that happy hooey. Lee Johnson, [e-mail], former dep. dir., Portland (OR) Energy Office.

2007 Jul 06 05:45 PM

[intaicheong:]

there is no shortage of oil and gas, no oil running out, for lord will provide. neither global warming. liberals(immorals) always come up with a hoax. science is imperfect always. we will always scratch the surface of nature.

2007 Jul 08 08:09 PM

[Walter Morton:]

Lee Johnson's analysis is correct. The last century of inexpensive liquid fuels has led us to a situation where we are just learning consumers need to do more sophisticated "energy math." The "energy cost" most Americans are familiar with is a measure like "miles per gallon" for a car, which has in a minor way influenced choices if buyers are seeking lower cost of operation, but efficient MPG has not been a "critical" factor in USA car sales for the last twenty years. Only as recently as 2006 have SUV sales "slumped" while "hybrid" sales taken off. Still, few people see that their car represents long-term energy costs of mining metals, building factories to make steel, glass, plastic, etc. People do not take the long view of infrastructure costs, they see a gallon of milk is $1.29 -- they don't think much about the cow, the farmer, or the field in the sun. Net energy theory looks at how you measure if you get "more energy out" than you "put energy in." A solar cell produces power for 25 years. But costs 3 barrels of oil (in energy equivalents) to manufacture. At what point -- if ever -- are you making a "net gain?" Cars and trucks are only an "efficient" method of transportation if gasoline is plentiful and cheap. As it becomes scarce and expensive, alternatives like rail become efficient, and will replace them. This conclusion requires a little understanding of math, physics, and free market economics, but is essentially inarguable if you look at the numbers. I'm not sure how Buffet is modeling "the numbers" for railroad's superior efficiency in moving large masses of goods, but it's pretty obvious if you've ever watched a train that it can carry a larger load from point A to point B than any truck. QED.

2007 Jul 16 12:15 PM

[jim_bird:]

If Warren Buffet wanted to run trains and make a profit doing that, he could have easily done that with a 22% stake in the company. What this additional investment offers him is the ability to have full control over the railroad and more importantly the land easements owned by the railroad. These continuous extremely powerful land easements currently allow the railroad company to do what they want on their land and the surrounding communities cannot comment much about what is done on railroad property. By purchasing the complete company Buffet will have the ability to reshape the entire usage of the railroad land - most importantly install high tension lines along the railroad lines. In looking at a map of the railroad lines, one could conceivably run high tension lines from the renewable energy rich plains directly into most central, midwest and mountain cities of the US. Additionally, in looking at the existing high tension line distribution facilities in the mid-west, there is no where near enough capacity to support the addition of geographically distributed wind electrical generation plants. But such land easements will facilitate Buffet in bringing this inexpensive power generation source to market - and at a significant profit to boot.

Nov 04 03:23 PM