Monday, February 22, 2010

What I Learned, Part V: On Expected Returns and Diluting the Berkshire Gene Pool

“What is the expected return on capital from Burlington?” asks the shareholder from Hamburg, Germany. “And if you can’t buy more railroads would you expand into shipping?”

As Warren Buffett launches into his answer, I muse that this is not the first time a German has asked the best question at a Berkshire shareholder meeting.

In “Pilgrimage to Warren Buffett’s Omaha” (McGraw-Hill 2008) I described the one and only question that really challenged Warren Buffett throughout more than five hours on a Saturday morning two years ago—and it was asked by a shareholder from Bonn.

The fact that only one question—out of more than 50 that day—attempted to scratch the surface of the Oracle’s brainy-but-folksy demeanor is not as striking as it might appear to those who have only seen Buffett hold court on CNBC, where he dispatches opinions on everything from the inheritance tax to railcar statistics.

Despite the fact that the centerpiece of the annual “Woodstock for Capitalists” is a five-hour, no-holds-barred question-and-answer session with Warren Buffett and his vice-chairman, Charlie Munger, the fact is that in recent years not many shareholders asked questions even marginally related to Berkshire and its businesses.

All that changed at last year’s meeting, of course, when Buffett eliminated the first-come, first-served lineup at the microphones and instead selected three financial journalists to pose questions submitted in advance by shareholders and anyone else with an internet address.

The new format eliminated the tendency of past meetings to veer towards “What Would Warren Do?”-type queries from awestruck acolytes asking Buffett advice on how to become a great investor, or what issues Buffett would tackle if elected President, or—and I am not making this up—“Do you know and believe in Jesus Christ, and do you have a personal relationship with God?” (The answer to that one is—well, buy the book and find out.)

Indeed, at the May 2008 meeting only one question related to the businesses owned by Berkshire Hathaway. It was also the only question Buffett ducked. (By contrast, he answered the “Jesus Christ” question as he answered most of the rest: straight ahead, with no irony.)

And that was too bad, because it was a great question that indirectly got to the heart of what will likely become the central issue at Berkshire Hathaway: what happens when Warren Buffett—the best capital allocator in the world—is no longer allocating capital at Berkshire.

Using Berkshire’s See’s Candies as an example, the Man from Bonn asked whether Buffett would prefer a slower-growing but higher-margin business, as See’s is, to a global but somewhat lower-margin business, as Swiss chocolate giant Lindt & Sprüngli has become.

It is a an excellent observation: when Buffett and Munger bought See’s for $25 million in 1972, it was a small, west-coast candy company. 37 years and $1.5 billion in profits later, See’s remains a small, west-coast candy company.

While that’s good news for Berkshire shareholders—after all, Warren Buffett reinvested that $1.5 billion of cash from See’s into other high-return opportunities, to the benefit of Berkshire and its shareholders—it’s not necessarily good news for See’s Candies in a world gone global. (To see how Buffett ducked the German’s question, read “The Decline and Fall of the Sainted Seven,” Chapter 36 in “Pilgrimage.”)

The question asked today by the shareholder from Hamburg is equally good: “What is the expected return on capital from Burlington,” he has asked, “And if you can’t buy more railroads would you expand into shipping?”

This time, Buffett does not duck it.

“I think the return will be satisfactory but not mouth-watering,” Buffett says. “It’ll be similar to our energy utilities.”

Berkshire’s utilities earn decent, regulated returns on investment—not remotely close to the See’s Candies-kinds of returns that most investors associate with Warren Buffett—but “satisfactory” nonetheless.

The reason “satisfactory but not mouth-watering” returns are appealing to a guy famed for growing Berkshire’s book value at 20% a year for 45 years is simple: the sums involved are so vast ($43 billion, give or take, in total capital for the Burlington Northern deal), that a “satisfactory” return on this elephant-sized investment means a lot of money will be coming in Berkshire’s door every year for many, many years.

And any money manager—Buffett, especially—will tell you it is far more difficult to grow large amounts of money than small. In Burlington Northern, Buffett has found precisely the kind of “elephant” he has been hunting for years.

That does not mean, however, Buffett thinks the Burlington acquisition is without risk.

By comparing the railroad business to Berkshire’s existing utilities businesses, Buffett makes an important point. For unlike See’s Candies, which sells a discretionary consumer product and therefore may raise prices or introduce new products or enter new markets at will, the railroad business is subject to significant oversight from the Feds—less so than in the past, when pricing was regulated, but still significant—much like a regulated utility.

Indeed, at this very moment, Jay Rockefeller’s Senate Commerce Committee is considering new rail legislation to beef up regulatory oversight and put the screws to railroads—legislation that the CEO of Union Pacific, Burlington’s chief rival in the west, complained about on his company’s recent earnings call.

And so it is that Buffett proceeds to discuss the risk this government interference poses:

“We are counting on society to behave well with us in allowing us a reasonable return on capital IF we do our job of behaving reasonably well,” he says.

Asked next what would happen if government regulation got “more intense” on railroads, Buffett says matter-of-factly:

“The governments could strangle our utilities… They have the ultimate authority…they could raise the corporate tax rate to 80% or something…

Our basic position is that if we behave well, they’ll behave well. Our utility customers oughta feel very sure that when they flick a switch the lights’ll go on,” he says, adding, “They’re gonna need the railroads in this country big time.”

Buffett’s age (he’ll be 80 in August) seems to be catching up with him: despite shielding his eyes from the glare of the spotlights, he can’t discern from which microphone in the crowd the next question is coming from. He looks intently at the unused microphone near us while the shareholder asking the question is at the microphone on the other side of the concert hall:

“How would the stock split affect Berkshire’s ability to be in the S&P 500?”

It is a bit unsettling to see Buffett continue to stare at nobody, but the spotlights are bright and what the hell, this is Warren Buffett, who cares where he’s looking?

Besides, this is a question with big dollars at stake. Berkshire is not in the S&P 500 Index, despite the fact that its market value is larger by far than any other company not already in that index—and bigger than most that are in it.

The reasons Berkshire has been excluded up to now are straightforward: two of the Standard & Poor’s Index Committee’s five ‘admitting criteria’ haven’t been in Berkshire’s favor since the day Buffett took control in 1965—one being trading volume and the second being the amount of stock in public hands.

Before the Burlington deal was announced in early November, a less-than-whopping 40,000 shares of Berkshire “B” shares traded on a good day, not adjusted for today’s proposed 50-for-1 stock split. And the volume in “A” shares, through which Buffett controls Berkshire, barely rounded up to a 1,000 a day prior to the announcement.

Answering the question, Buffett observes:

"We’re by far the largest co that’s not in the S&P 500… the A/B situation creates problems for us, but eventually we’ll be in the S&P 500, we’ll be so large.”

So far, so clear; but it is in discussing the effects of this dramatic change in his shareholder base (over which Buffett was once so obsessed that he used to keep track of how many shareholders lived in his own zip code) that Buffett exhibits the ability to rationalize any particular stance that makes him so remarkable, and, to some investors, so hypocritical:

“If they put us in the S&P, it’s good for shareholders,” he says, because “if 6-7% of funds are in index funds it’s a block of stock that’s essentially there forever, which is EXACTLY what we’re looking for.”

Thus in one easy, plain-spoken sentence the investor who for fifty years has warned against following the herd; has railed against diversification by serious investors (“ass-backwards,” his business partner, Charlie Munger, calls it); and has refused to split his stock for fear of diluting the intellectual gene pool of the “quality shareholders” in the Berkshire Hathaway shareholder base, now blithely claims that index funds—big, stupid, mechanical, massively diversified index funds—are “Forever.”

If, by “Forever,” Buffett means “So long as Berkshire’s market capitalization stays proportional to the index,” then he’s correct.

If, on the other hand, by “Forever” he means “Whatever happens to Berkshire Hathaway,” he can’t be more wrong.

It is an astonishing piece of rationalization, even for most of the investors seated in this room, yet the prevailing reaction seems to be a shoulder-shrugging 'Warren-will-be-Warren'.

Buffett then rationalizes the effect on the Berkshire gene pool in an equally offhand way:

“By now our identity is pretty well known. I don’t worry about downgrading the quality of our shareholders.”

He concludes the stock-split discussion with one more remarkable statement:

"We should have done it when we bought Gen Re.”

The final question of the day gets to something that’s been on people’s minds since Buffett first announced the Burlington deal: what kind of hidden assets he sees in the Burlington railroad balance sheet.

To be concluded….

Jeff Matthews
I Am Not Making This Up

© 2009 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.


Anonymous said...

I look forward to all your posts especially re buffett. While I admire him, i think he speaks from both sides of his mouth. In the op-ed piece he says "I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities."

Now, I don't know if i'm splitting hairs, but about 2 months earlier to that article on cnbc with becky he says that he bought some WFC when it went down to the low 20's. Yet in the article he says he owned only bonds.

Since that article was written, he has been a net seller of equities in berkshire's portfolio, granted to fund other opportunities, but nonetheless he as been selling equities. The new opportunities were not equities (pfd's, corp bonds, etc) Someone should ask him if his personal account is 100% in equities now. I will bet its not.

While I understand capitalism and all, when WB bought the pfd stakes in GS and GE those firms used his name to sucker people into secondary offerings, who got killed initially and are still underwater in GE. Kudos to GE and GS for being able to do that, WB is out only for himself.

wroclaw said...

Jeff, so would he expand into shipping?

Alex said...

I appreciate the analogy linking BNSF to the utility businesses, but I am confused as to the nature of the financing. If the attractiveness of the deal comes from cost-plus earnings on leveraged assets (float + debt), then why is only 1/3 of the transaction financed by interest-bearing debt, and why does Buffett intend to pay back the debt in thirds over the next three years?

Berkshire is still underleveraged, and they can get fairly low rate financing even with the downgrades.

Alex said...

Sorry to double post, but I speculate that Buffett's changed stance towards the stock split may have a lot to do with his adjusted expectations of Berkshire's performance.

A company that beats its peers by 10%+ a year attracts far more attention than one that may not outperform on any given year, and only modestly outperform over time.

Anonymous said...

Professor Jeff:

Your post got me thinking: both railroads and utilties are federal and state regulated oligopolies. Both are the sort of "wide moat" businesses Buffett loves to invest in, even with their high capital expenditures. Buffett also invested in a couple of cap ex intensive manufacturers over the last couple of years as well; ISCAR and Marmon Group immediately come to mind. I wonder whether Buffett sees over the next few years these businesses being part of a domestic/global and cyclical economic reovery predicated on a return of capital investment in both energy and transportation? Just thinking out loud, and being this is only my opinion, I could be wrong, of course.

David Merkel said...

I don't always agree with Warren Buffett, but I do agree here. Index investors are passive investors. Individually, they are dumb. As a group they are smart, because they lower their investment costs.

Warren is also correct on Burlington Northern -- it should be like his utilities, and throw off a growing inflation-protected return over time, allowing him to earn a spread over his cost of funds (negative) that his insurance enterprises generate.

He is still a bright man after all these years.

PS -- I am a Calvinist Christian; the question asked regarding Jesus is not relevant to the short-term running of Berky, but is relevant to an Christian investor who cares about the ethics of the organization. Also, it is relevant to the long-term well-being of Mr. Buffett. The rest of us will have to face the results of that question one day as well.

But What do I Know? said...

Thanks for having the intellectual honesty to point out the S&P index "rationalization." WB does what he wants and explains away the inconsistencies afterwords--most of us do it (remember the line from the Big Chill) but the thing that annoys me is WB and his acolytes holding him(self) out as exceptional and holier-than-thou.

Jeff Matthews said...

Aaron, I'm not sure what Buffett's overall view is on manufacturing. Every deal he does is done at a price he believes is rational and will result in a desired return--not sure what the macro view is.

As far as whether Buffett would expand into shipping, stay tuned.


Colin P said...

As far as the shipping question goes, I bet Buffett gives some sort of noncommittal answer that is of little use to anyone in the investing world. Basically, he'll dodge the question in a friendly way without making anyone angry. Does anyone else agree?

Joe Keller said...

Hey Jeff,

Next time you talk to Mr. Buffet, hand him a copy of a very fine new book called "Waiting On A Train" by James McCommons.

I believe Mr. Buffet could single-handedly revive the American private rail business.