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.