Over-Analyzing Buffett: Railroads Are Simple
Much has been made of Warren Buffett’s mega-deal for Burlington Northern Sante Fe (BNI). It is the largest deal of his lifetime, and actuarially speaking, unlikely to be surpassed - in other words, it is likely the final significant brush stroke Buffett makes on his portrait that is Berkshire Hathaway (BRK-A, BRK-B). When the greatest investor of our time makes such a statement, it bears watching, but with the caveat that too much can easily be made of a relatively straightforward transaction. Railroads have three major favorable traits:
1. Structural cost advantages compared to other forms of transportation
2. Rail track infrastructure is a network that cannot be duplicated
3. Tax advantaged status
#1 relates directly to the relative cost of transporting goods via rail compared to freight truck. While this is a generally incomplete comparison since the capital expenditures are radically different, it’s true that rail is much more efficient at present energy prices - and that gap only increases as fuel becomes more costly.
#2 is the reason Buffett would buy a company like Burlington Northern, as opposed to a trucking or shipping company - i.e. DryShips (DRYS). Burlington Northern has localized monopolies in areas its track infrastructure reaches, which amounts to a toll on the movement of goods; truckers or shippers only operate the physical transport vessels and have no claim on the medium they move through, making them inherently inferior businesses.
#3 is an overlooked item, in my opinion. Smaller railroads are heavily subsidized with tax credits and the like for investing in their networks, and although this helps Burlington Northern less, it’s one small positive edge they have. The real kicker, though, is that the underlying assets creating value for Burlington Northern (again, track infrastructure) are perpetually carried on the books at a discount to market value, and the appreciation of those assets is not recognized for tax purposes. This creates a permanent carry trade where non-replicable assets (see #2) can grow steadily in value, all tax-free, for an indefinite time period. So although many will point to the seemingly-high (for a “value investor”) earnings multiple Buffett paid, the value of Burlington Northern isn’t in 2010 earnings estimates, it’s in the value of a unique business with a non-replicable asset base.
My largest personal holding is a small-cap railroad stock that I feel is a chronic underperformer, but one with little downside in its present form and significant upside in a turnaround scenario. My bet is that railroads will be a good business that creates value for customers and shareholders, and it’s comforting to have one of the world’s wisest evaluators of businesses betting in the same sector I am.
Bank Bailout Report Card: What Are We Grading?
Earlier this week, I gave a presentation on Merrill Lynch, the differences between it and other investment banks, and why Bank of America’s (BAC) acquisition of the company in its dying days of September 2008 was not necessarily a bad idea. While a tough position to argue on its face, there are actually many reasons justifying such a deal - combining an unstable investment bank with a depository institution is effectively what the Federal Reserve did the next week in allowing Morgan Stanley (MS) and Goldman Sachs (GS) to become bank holding companies, for example. In the short-term, however, a world of rising credit losses will make any deal of that type look to be a poor move, however. Yet basing a decision purely on hindsight-rich outcome is analogous to saying an energy E&P company is poorly run if they start drilling new wells only to see crude prices fall.
Why do I say this? Perspectives can shift quickly, and create unfair comparisons when time horizons or end goals differ. With the bankruptcy filing of CIT Group (CIT), the government is opening itself to questions about the effectiveness of TARP, as the $2.3 billion preferred investment in CIT is in great jeopardy. The purpose of TARP, however, was not to maximize the government’s return on investment; it was to stabilize the financial system (using kind words) or save it from collapse (more bluntly) with a minimum of losses. TARP was a large check the government had to write to buy time, and it definitely succeeded in accomplishing that.
In the last month, I’ve been asked numerous times for thoughts on the financial crisis fallout, having had a year to reflect and see how things have played out. The simple fact that we’re having discussions about the banking system a year later means that TARP achieved its purpose, and the bankruptcy of a relatively smaller financing company like CIT Group doesn’t seem to change that. With the benefit of extra time to assess the choices of the Treasury Department, alternative solutions could surely have been devised that would have rewarded the U.S. government more - but again, that was not the purpose. Though I feel TARP was a good first step toward stemming the crisis of confidence that (rightly or wrongly) gripped the markets in the fall of 2008, the lack of follow-through to reforming the financial system and minimizing future systemic risks is a disappointment. That, however, is a knock against the politicalization of everything Wall Street that came afterwards, not TARP itself.
See here for more discussion on this and other topics.
Why Solar Stocks Are a Long-Term Sell
Amid a number of earnings releases from leading solar companies First Solar (FSLR), Sunpower (SPWRA), and MEMC Electronics (WFR), there is plenty of news to digest on such a dynamic sector. Regardless of how this particular quarter’s numbers pan out, I believe one inevitable truth will eventually assert itself: solar stocks are nothing special.
Solar stocks generally trade at generous multiples to book and EBITDA, and some of them seem to deserve premiums because of high profitability numbers. First Solar, for instance, has operating margins just shy of 40%; MEMC has operating margins of 25%. But such situations rarely persist, and given the industry value chain the solar companies operate within, it will be almost impossible for the great number of competitors to all come out ahead.
Although solar stocks often carry a sexy perception of growth and technology, the reality remains that the companies are beholden to electricity producers - namely regulated utility companies domestically, and either similarly regulated utilities or government-backed enterprises globally. In other words, the customer base for solar companies consist of utilities with limited ability to generate profits or governments with enormous bargaining power. Those are conditions that lead to a vicious price war that undermines profitability for the entire sector, not consistent growth with steady bottom-line results to match.
My view of solar stocks may be different than many market participants, but the interest and amount of capital that has followed the green energy space is a sign in itself that the industry as a whole is not likely to have excellent potential in the near future. In general, a good strategy in these situations is to sell when speculation becomes rampant, but that’s not the case at present - most of the stocks are down significantly from their summer highs, and the recent plunge is only a continuation of that trend.
Natural Gas and Oil Divergence
The TK blog wonders why crude oil prices (proxy ticker: USO) and natural gas prices (proxy ticker: UNG) have undergone such a divergence of late. Professor Donald Marron shows that the historical trading range — where crude typically trades at 5x to 10x the price of natural gas — has been blown out of the water, and crude now trades close to 24x the price of natural gas. Considering that one barrel of oil (the price unit quoted) has 6x as much energy as one thousand cubic feet of natural gas (the price unit quoted), the trading range makes sense. But that’s done you no good if you’ve entered a paired trade of long nat gas and short crude, as the squeeze has cost you money so far.
Consider three factors that affect both crude and nat gas: supply, demand, and technical pricing. There haven’t been any significant new discoveries of oil lately — but the Haynesville Shale discovery could yield a decade’s worth of natural gas consumption at below-market production costs. That’s one strike against natural gas bulls. As for demand, about 45% of oil is used as fuel for motor vehicles - a relatively inelastic demand source. Other major demand components are propane and asphalt, so if you’ve been driving, grilling, or hearing about infrastructure spending as a source of stimulus, you should be aware that all translates to higher demand for oil. In other words, oil demand typically peaks during the summer, whereas natural gas…
Normally peaks in the winter, since it heats and cools more than half of homes in America. But it has been a cool summer, and industrial activity (35% of natural gas consumption is residential, 25% is industrial, and 21% is for electricity generation) is tepid at best, and overall electricity demand is down. This translates to less-than-usual demand for natural gas. That’s two strikes on natural gas bulls.
Finally, technical pricing factors. Crude oil is denominated in dollars worldwide, whereas natural gas is a more localized market. This means that as the dollar falls relative to other currencies, the price of oil on the world market increases. The dollar (proxy ticker: UUP) has fallend 12% in the last six months, and that has contributed directly to the rise in oil with no benefit to natural gas. Taken together, these three powerful factors show why natural gas bulls have struck out on their bet for higher prices, and what factors they need to turn in their favor if this trade is to reverse.
