Thursday, November 5, 2009

Bad companies and good investments...

One of the big news items of the week is Berkshire Hathaway's acquisition of a Burlington Northern, a large US railroad.
http://www.nytimes.com/2009/11/04/business/04deal.html
Since Berkshire Hathaway is Warren Buffett's brainchild, this has provided a platform for many analysts to read the tea leaves. Here is some of the spin that I have seen and what I think about the spin.

A significant number of the analysts have argued that Buffett is making a bet on the US economy recovering by making this investment. I find this puzzling at two levels. First, if you were going to make a bet on the US economy, railroads seem like a pretty poor choice. Unlike housing and consumer durables, railroads have not seen their earnings increase dramatically in good economic times. Second, Buffett has always expressed his skepticism about market timing and macro investing strategy and this investment would be a significant departure.

Here is my take on the investment. Railroads in the United States are the quintessential mature business. It is extremely unlikely that you will see much real growth in this business; constructing a new railroad or even adding new rail lines would have prohibitive costs in the US, given real estate costs and litigation issues. Companies in this business have earned returns on invested capital that have lagged the cost of capital for decades. Put another way, very few railroads would make the list of most glamorous companies or be featured in Tom Peter's list of excellent companies.

So, why would Buffett invest in a bad business? I have said some unfavorable things about Warren Buffett on this blog before. At the risk of repeating myself, I think he has been hypocritical on corporate governance and he plays the "I am just a hick from Omaha" role to perfection. However, I think his status as a great investor can be boiled down to his capacity to separate "great companies" from "great investments" . Put another way, Buffett has always recognized that a great company can be a terrible investment, if you pay too much for it, or that a mediocre company can be a great investment, at the right price.

Here is the bottom line. I don't think that Buffett's investment in Burlington Northern is a bet on the US economy or an expectation of a surge in profitability for railroads. I think it reflects a more prosaic choice. Buffett thinks he is getting a good deal for the company at the current price, and he has history on his side. The best investments in the market are often among the companies that are viewed as the least glamorous and most boring: Burlington Northern clearly fits the bill.

17 comments:

Immortal said...
This comment has been removed by the author.
Immortal said...

thts wat i like abt this man...he stick to his investment approach n keep it simple....28% gain already with jst the purchase for a stock that was tradin flat is testimony to your views Prof" Market is more of followers than leaders"...but we shud be happy to keep followin buffet as long as he keeps his investment approach simple n clear which he has done for over 4 decades now barring few in between...

Yasser said...

Prof. Damodaran. Thanks for another good post. Mr. Buffet is reaching a mature age and it could be that he is trying to repay America for the good life he has had. U.S. is undergoing a deep recession (unemployment rising over 10% - the worst in 26 years?) and Buffet has decided to invest in America. It is a low growth business, maybe Buffet is trying to give a signal this time around that he is investing in macro-America's future. Everything is going to be fine - a farewell investment from Buffet...

Ankit Soni said...

@Yasesr - I agree with the prof here. But why do we need to see Buffet as "good person" to admire him as an astute investor?

I do not see any correlation or causality between being a nice person and a good financier.

bob said...

Professor Damodaran

Astute observation. One point that may be relevant. Do you think that Warren made that investment since he may have a point of view on the future price of oil. Since rail is the alternative means of transport to the road network, he is possibly betting that oil prices will go up in the future, thereby making rail transport more attractive.

Kind regards,
Bobby

custodes said...

I agree that this who "bet on the US economy" is a spin designed for CNBC. Buffet would have estimated the earnings power of Burlington against the replacement value of its assets and on that metric, this deal would have made sense. Nothing else. This is true to his typical value style deals: a business with very high barriers to entry, with stable cash flow and flat capex. Although off the top of my head, I am a little skeptical about your comment on ROIC being below WACC, but I could be wrong. I would imagine if that was the case, these guys would probably have needed a tax payer sponsored equity infusion as well.

Accounting Tutor said...

The market value of its assets (prime property in many locations) is a big part of the price in my opinion. I dont have the data to do the analysis but I think it may be more than the operating value of the business in today's prices! This will give him his Margin of Safety. He is still a value investor.

krasen said...

I agree with Bob and see the Buffet railroad investment as a hedge against potentially skyrocketing oil prices, not the best possible investment choice, though. Besides, as far as I know, this year Goldman Sachs don't want to issue preferred shares courtesy to the Fed zero-interest rate policy.

Yasser said...

I wish to diagree with Bob and Krasen that the investment is a hedge for a future hike in oil price. Please note that the sector in which Buffet has invested, means the investment will remain invested for many years to come. Oil forecasting is a tricky business and one cannot predict what will happen to oil prices long into the future - a time line that matches the investment, if I am not wrong. Wallstreet journal has likened Mr. Buffet to a billionaire boy for playing with trains. Maybe I was wrong about Buffet reaching a mature age...

valuhunter said...

For better or for worse, I believe there is a great deal more to the transaction than a simple cash flow play. I do agree that the BNI business is a tightly managed cash flow machine -- but you can't deny there is an inflation play here whereby the replacement cost and underlying asset base are rather impressive. Further, we need to consider the liquidity benefits received by BRK shareholders when this transaction is viewed as part of a larger deal involving the 50:1 split, inclusion into the S&P (potentially) and a substantial increase in the number of shareholders (potentially offsetting the Gates Foundation mandated sales).

Lots to think about here. Some pros, some cons -- more than meets the eye.

Yasser said...

The Economist's most recent edition has a story on the same topic and they give out some new reasons such as infrastructure investment tax subsidy by the Obama administration. It is a good read.

Thanks,
Yasser

Gaurav Mehta said...

I think the deal is being made a lot complex which i don't think it is. Buffet is close to 80, he needed to invest all the money in one right investment. It's just that right now he was getting the business that he likes and rails are safe cash flows. Getting to earn close to your cost of capital on such a big investment is definately worth putting the money. It's easy to get great returns on small investments but with $30-$40billion even if you can make safe 8-10% that should be good enough.

He has just played it safe as he has always done, invest in safe mature companies, thats his style. If you look at his non traditional investments like NetJets, they haven't been doing well in a bad economy.

His like for US as a economy is limited to the fact that he made a lot of money from it. A clear example being: Wachovia Bank asked for an aid from him in the crisis, he liked the business but he did what suited him, bid for Wachovia through Wells Fargo rather than bail Wachovia.

Buffet might look a lot comlex but his investment strategy is pure simple three pointer.

1) He chooses the business he likes in the good times.
2) Waits for a year like 2008-2009, gets further bargains and deals on some these companies and invests.
3) Sticks to his good companies forever and exits the bad investments when ever he gets the opportunity.

Josh said...

How can railroads be sustainable when their return on capital is consistently below their cost of capital? What am I missing?

perpetual wonderer said...

@ Josh...I too was wondering about the same thing. But I guess, because of a host of reasons, railroads qualify for subsidies, tax payers' grants, other benefits in tax etc. for the investor(being alternative transport etc). Due to this infusion, for the investor, the return on capital (he has) employed becomes slightly more than the expenses that he has to fund. So it works out to be a reasonable investment. But thats just my understanding. Could someone clarify please.

Aswath Damodaran said...

How can a business that earns less than its cost of capital keep going? There is a simple reason. The capital that is tied up in these businesses cannot be easily extracted. In other words, liquidating a railroad will not yield a liquidation value = invested capital. Thus, continuing to operate a bad business may generate a higher value than liquidating it.

Gaurav Mehta said...

Jush what you are missing is that Burlington's Return on Equity is close to 16% and its cost of equity close to 8 -8.5%. This is one of the main reasons that Buffet has invested in this company, infact what i feel is that Buffet expects the ROE to stay above the Cost of Equity for a long enough period and thats what has made me pay for the Company close to or slightly over what's it worth. (I actually valued the company today).

Gaurav Mehta said...

Josh .....what you are missing is that Burlington's Return on Equity is close to 16% and its cost of equity close to 8 -8.5%. This is one of the main reasons that Buffet has invested in this company, infact what i feel is that Buffet expects the ROE to stay above the Cost of Equity for a long enough period and thats what has made me pay for the Company close to or slightly over what's it worth. (I actually valued the company today).