Anthony Alfidi's  Instablog

Tuesday brought big news on Berkshire Hathaway's proposed buyout of Burlington Northern Santa Fe ($BNI) railroad at $100/share, cash and stock.  This transaction is a textbook window into Warren Buffett's equity valuation model.

Uncle Warren has dropped hints over the years on how he values a stock.  Buffettology books (particularly those by Mary Buffett) have done an excellent job outlining his calculation of "owner earnings" (net income plus depreciation minus average capital spending), his use of the 10-year Treasury yield as a discount rate, and his preference for companies that consistently grow retained earnings per share over long periods.

I built an equity valuation model using these principles and got an interesting result.  Discounting $BNI owner earnings for the past four quarters at a discount rate of 3.5% (approximately the prevailing 10-year Treasury yield in recent weeks) results in a share price of slightly more than $150.  Warren Buffett doesn't buy anything unless he can get a severe bargain, so paying $100 for a stock he believes is worth around $150 represents a 33% discount. 

I believe Uncle Warren's key insight is his tweaking of the growth factor used in traditional DCF models.  In place of the "b" retention rate for net earnings not spent on dividends, he substitutes the average long-term growth rate of retained earnings on the balance sheet.  Multiplying this modified "b" by his version of ROE (owner earnings divided by shareholder equity) gives us the annualized growth factor "g" that he uses to estimate those future owner earnings. 

I'm intrigued that Uncle Warren chose to assume $BNI's relatively high long term debt load onto Berkshire's balance sheet.  Apparently he thinks the cash flow from Berkshire's finance and insurance lines will be sufficient to pay that off.  If this gamble works, it gives Burlington the operational freedom needed to continue investing in technological innovation.

It's almost a done deal pending regulatory hurdles.  Anti-trust scrutiny will probably force Berkshire to divest its other rail holdings, namely Union Pacific ($UNP) and Norfolk Southern ($NSC).  Forced selling of those large stakes might make them attractive plays for other value-oriented transportation sector investors.  It would also give Berkshire additional cash if they need to sweeten this deal. 

My play?  I immediately sold a few short puts under $BNI at 95 on the premise that Buffett's bid establishes a firm floor for the stock and will be approved without any glitches early in 2010.  The worst-case scenario for this special situation would be a market dislocation that tanks Berkshire's own share price, forcing it to further dilute its own shareholders to maintain the agreed mix of cash and equity for this buyout.  If my puts are exercised against me, my own worst-case scenario is that I end up owning a long-term position in either $BNI (if the deal collapses) or Berkshire, two companies that the greatest investor of all time thinks are terrific to have. 

Full disclosure:  Anthony J. Alfidi is short Jan 2011 puts on $BNI at 95 (covered with cash) and holds no position in any other stock mentioned in this post. 

Sometimes I think financial writers want to make investors become stupid.  Judge for yourself with this one:
 

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The evidence mounts that the U.S. economy is not in recovery mode: 

Demand for U.S. durable goods unexpectedly fell in August, signaling companies are planning to curb spending on concern gains in sales will not be sustained.

The lasting damage of programs like Cash for Clunkers is to fool pundits and consumers into thinking we can borrow our way out of an insolvency-induced contraction.  Purchasing managers and operations managers should know better, hence their realism in trimming orders. 

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I once respected Ken Fisher.  I thought he had some interesting things to say about arbitrage pricing when he spoke at the San Francisco Money Show in 2002.  I lost all respect for him when he spoke there again in 2006 after he claimed that American's home equity was a good substitute for savings in the bank. 

Ken Fisher has now given me a reason to never consider respecting his opinion again with his call for massive increases in Americans' debt:

The U.S. has too little debt, not too much, Fisher says.  The U.S.'s return on assets is high and interest rates are low, so our borrowing capacity is much higher than our current debt levels.

Also, Fisher says, you have to look at the U.S. in the context of the world, because the U.S. is only 25% of world GDP.  The world is way under-leveraged, so one country's particular debt-to-GDP ratio doesn't matter.

Some financial icons manage to outlive their reputations for brilliance.  Warren Buffett and Alan Greenspan come to mind.  Now it's Ken Fisher's turn to be ignored.  Apparently he hasn't watched I.O.U.S.A. or visited Perot Charts.  Maybe he's still stuck in the 1980s when his acumen as a portfolio manager and analyst was at its peak. 

Folks, please don't listen to Ken Fisher if you want to survive the next few years of malaise.  Just stay out of debt for the foreseeable future.  That's my own plan. 

I've been busy for quite some time working on a very large project, but I have made time to publish a special report on valuation methodologies for IPOs. Check it out at Alfidi Capital.