Sunday, November 22, 2009

Buffett "Has Lost His Mind"

In the article Berkshire + Burlington, I argued that Berkshire's 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. Nonetheless, 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.


Disclosure: No positions.

13 comments:

  1. According to this paper (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=973790), Buffett made his best decisions 25 years ago. Perhaps the run from $5000 to $150,000 explains that! Unfortunately, there's no telling what the next 25 years holds, but I'm not too keen on what happens in 2109 as I don't intend on being here!

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  2. I tend to agree with you that this was not a great deal.

    However, one argument I recently heard is that there actually is a lot of hidden asset value the RR rights-of-way since they can also be used for DC power lines. Given the expected need in MidAmerican's footprint (much of which overlaps with BNI) for energy transmission infrastructure (DC lines from wind power in the Dakotas and midwest, natural gas pipes north and west from TX & OK and east and south from WY,CO & Canada), these railroad rights-of-way could be crucial. Add to to that an increasing demand for the low-sulfur coal from WY which will need to travel on these rails to many of the power plants in the east, and I think you have the "hidden" portion of the value.

    I have not run the numbers on this (do not own BRK and don't want to), but that hidden value is how Buffet will prove skeptics wrong, if he does.

    No matter how you slice it, though, it is a long-dated call option on crude prices.

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  3. I think Greenwald addresses these issues. They don't justify the price paid for BNI.

    Thanks for reading.

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  4. Except that Greenwald is wrong when he writes, "there's nothing you can do with those rights of way."

    He is correct that you often cannot sell them to another party, but my understanding is that you can lease them to another company for high voltage transmission etc., or in the case of BRK, have your energy company build on them for free. I know that the co-siting has been done in New York state, and as you can see, the government is receptive:

    http://online.wsj.com/article/SB12375998488063.html

    http://www.gao.gov/products/GAO-08-347R

    It is, of course, entirely possible that Buffet and Sokol got an advanced read on the likelihood of this repurposing of rights-of-way being approved.

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  5. A similar argument was made regarding railroads during the Internet bubble. It was all about "fiber". The telecom companies were going to pay big bucks for access to the rights of way. It marked a cyclical top in railroad valuations. This may have gone into Buffett's thinking, but this is too small of an issue to justify the insanely high premium. Besides, I'm sure Berkshire could have made an attractive deal with BNI without acquiring them first.

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  6. I BELIEVE ANOTHER MISTAKE HE MADE WAS TO PURCHASE CARMAX. IF I'M WRONG I HOPE SOMEONE WILL POST IT. I WAS ALSO SURPRISED HE SOLD COP STOCK OR LOWERED HIS BUY.

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  7. If you've studied Bufffett's investments over the past five decades, he almost always comes out on top. True, there have been losses along the way, but you don't get where he is today without assuming risk. WB has a way of seeing what other investors don't, and he often goes against the grain. I say the deal will, in time, oay well for Berkshire Hathaway.

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  8. Talk about going out on a limb: Buffett is a pretty good investor? Ya think?

    The deal is out of character. If it works out well, it will be despite the price paid, not because of.

    I've followed Buffett for 2 decades anyway. And I can say with confidence that he broke his own rules with this deal.

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  9. Buffett has had far more winning investments than losing ones. Fairly obvious to be sure. The point is: He has had some losers!

    That seems to be news to some people, who defend every Buffett action as infallible. Buffett is human and fallible, even in the areas of investments.

    I think BNI will go down as a mediocre purchase at best.

    Thanks for reading.

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  10. I am the poster who wrote the posts on November 25th. The other two "anonymous" posts below those were other posters.

    I just want to make clear that I agree with you: using any traditional value-based approach the BNI deal looks bad. I am merely suggesting that since we know the following:

    1. Buffet is a smart investor,
    2. He owns MidAmerican,
    3. There is an expected need for HVDC transmission on the footprint of MidAmerican and BNI
    4. FERC is at least considering allowing the repurposing of the RR rights of way as a mainstream practice
    5. Low sulfur coal coming from Powder River Basin in WY will incrementally boost volumes on BNI tracks

    That it might make sense to conclude that Buffet probably IS up to something beyond his traditional value-based strategy, and that something may very well have to do with 2-5 above.

    And I was merely trying to set the record straight when Greenwald wrote that "there's nothing you can do with those rights of way." There is in fact precedent and momentum behind doing something with them that does create additional economic value.

    The fiber precedent is a good point, though, and though I think there are key differences this time (fiber is built denser and is less sensitive to needs like straight-lining and access to specific rural geographies where BNI rails are built), my overall takeaway is that Buffet did overpay. Just saying let's not dismiss it wholesale given some potential for value-creation that you and I may be more in the dark on than Sokol and Buffet.

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  11. Agreed. Your points are well made and I agree with them in principle. Thanks again Anonymous... please sign up so we know who you are. Again, thanks for reading. Come back again.

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  12. Dear Mr. Lonely Value,

    I must agree with your negative view on Berkshire's BNI purchase. Although the use of stock is (mostly) out of character, the acquisition does fit Berkshire's foray into utilities over the past decade: relatively low ROE government-sanctioned monopolies/oligopolies with relatively high debt levels. Like the utilities, one isn't going to lose much sleep owning a company like BNI, but it is frankly hard to justify using shareholder funds to purchase these assets at a premium.

    Perhaps you might comment on these points:
    1. This acquisition was done so that Buffett could sleep well at night, knowing he has now put the lion's share of Berkshire's capital to work, without him having to go against his stubborn policy of not paying dividends.
    2. Like his "bets" on currency and index derivatives, Buffett has morphed into a top-down macro investor.
    3. Buffett is getting the company ready for David Sokol to take over as CEO.

    I am an admirer of Buffett. He has compiled an amazing track record over the decades without following trends or compromising his ethics. However, it almost feels as if he is throwing in the towel on his great project, like he has mind on Berkshire after Buffett.

    Buffett's investment wisdom is timeless, but for those of us who have followed his investing over the years, Berkshire's time has passed.

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  13. I am the "anonymous" poster you referred to in your last comment (not the one directly above this though). I have also commented on your Ternium posts once or twice. From now on if/when I comment I will comment as Bill K.

    Take a look at LGT.B on the Toronto Stock Exchange. Very illiquid (76% insider owned) and small cap, but the story and the value are pretty good if you are willing to buy and hold.

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