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Buffett's Railroad Acquisition Illustrates Several of My Investment Strategies

Posted November 17, 2009

Topics: Finance & Investing

Warren Buffett’s acquisition of the Burlington Northern Santa Fe (BNSF) railroad brilliantly illustrates several investment strategies that I recommend in my book Full of Bull. While the deal made headlines because of its size—$34 billion—I realized upon reading some of the details that Buffett’s rationalization underscored my own strategy of investing in themes and rising industry sectors, holding stocks long-term, and being value oriented.   

The way to take long rides on stellar performers is to invest early in an industry sector that is breaking out for decisive, sustainable reasons. Identify an area where business prospects are shifting positive or where circumstances should be improving over the next few years. Stick with sectors that are still underinvested and underexploited. Identify the emerging new theme, but be cautious of trends or fads.  Sometimes they might be narrower, more mature, or already fully exploited by investors by the time you recognize them. A decade ago if you began investing in energy stocks the investment returns were stellar, almost 150%. That was the theme of the decade. Conversely, the technology and telecom areas were sectors to avoid, loosing around 8% annually, and financial stocks fell some 3% per year on average. Themes tend to endure for many years but you need to get it right.

The theme that Warren Buffett espouses in his BNSF purchase is that rail transportation is more cost effective, more environmentally friendly, and less competitive than long haul tractor-trailer trucking. Some 43% of all freight is now cared by rail—almost 50% more than trucks—and rail transportation is gaining market share steadily. Trains can move a ton of freight 470 miles on a gallon of diesel fuel compared to 130 miles for trucks. Each railroad train displaces 280 trucks on the road. A new freight car costs $8,100, about one-third the cost of a tractor-trailer. And there are virtually total barriers to entry in the railroad industry, as no more new major railroads being constructed. In fact, 40% of the tracks in the U.S. since the 1980’s have been abandoned. 

Another investment strategy that I firmly adhere to is to hold stocks long-term, at least one year and preferably for several years. The best performers are invariably stocks that prove to be winners over five to ten years. Perfect timing in entry price and capturing the top price tick on the sale is impossible. Such factors are minimized if you are investing rather than trading. Investing also implies lower capital gains taxes and fewer commissions. This is a long-distance race requiring self-discipline and patience. How many times have you heard “you never lose money taking a profit?” Wrong. You pay a commission and full taxes on a short-term gain. And if the shares continue to climb for the next five years, the opportunity cost will be staggering.

There have been numerous studies proving that a long-range buy-and-hold strategy reduces risk. According to Burton G. Malkiel, Professor of Economics at Princeton University and author of the classic text A Random Walk Down Wall Street, in any given one-year or five-year period, the market return historically has ranged from a 25% to 50% gain to a decline of 25%. But in virtually any 15-year span, the annual market return has always been ahead by some 5% to 20%. A study by Ilia Dichev, a professor at the University of Michigan, detailed in The American Economic Review, reveals a 10% average return for investors who bought and held listed securities from 1926 to 2002. For traders, the return was 8.6%. And for buying-and-holding NASDAQ stocks from 1973 to 2002, the average annual return was 9.6% versus 4.3% for the typical trader.

Buffett’s investment firm, Berkshire Hathaway, holds stock positions for years, and in some cases like Coca Cola and Geico Insurance, for decades. It has already held stock in the Union Pacific and Norfolk Southern railroads for a few years. His contention that railroads will haul an expanding portion of things like food, coal, agricultural, and other bulk items over the next ten to thirty years makes it sound like he plans to keep his position in BNSF for many years.

The last investment strategy apparent in Berkshire Hathaway’s railroad deal is value. Not only do stocks that have low PE multiples carry less risk, but studies have proven that over long periods they also outperform growth stocks, even during bull markets. Growth stocks underperform value stocks because Wall Street tends to project the current earnings growth rate on into the future. If expectations are high, so is the valuation. Value stocks carry lower expectations and thus better prospects for a positive surprise. Stellar stocks, over time, have always started out with reasonable valuations. Even fabulous companies with brilliant prospects can be poor investments if the entry price is too high. Graham and Dodd’s book, Security Analysis, first published in the 1930s, stressed value investing as its key concept. It is still valid today. Many decades ago, Dodd made the comment to a youthful Wall Street student: “Always remember the Horace quotation—there is no substitute for value, and popularity has little to do with it.”

In the media coverage of the BNSF acquisition, an AP story quoted an analyst at Morgan Keegan claiming that Buffett is “buying in at the trough—things aren’t going to get much worse. He’s getting in at a good time.” Railroad profits have been depressed by the weak economy and their share prices have lagged. Buffett is always looking for value. He invested in Goldman Sachs during the time of the financial crisis a year ago, when the shares were exceedingly discounted. No matter how wonderful the fundamental outlook, he never chases stocks that are excessively priced.

Take Warren Buffett’s investment style and strategies to heart. Several of these, such as investing in themes, holding long-term, and value, are apparent in his purchase of BNSF.