Buffett’s Hidden Reasons For Buying Burlington Northern Santa Fe

Did Buffett overpay for Burlington Northern Santa Fe? The Oracle of Omaha surprised many of his followers by doing such an expensive deal. On looking behind the scenes, though, the reasoning makes sense…

The recent deal to buy Burlington Northern Santa Fe Corp. (BNI) is the biggest Warren Buffett has ever made. Buffett has called it an “all-in wager on the economic future of the United States.” The Wall Street Journal gamely characterizes the purchase as reflecting “long-term optimism” on the Oracle of Omaha’s part.

As usual, there are many who applaud the move. (It feels like some would cheer anything Buffett does, including taking a trip to the grocery store, but that is neither here nor there.)

Other long-time Buffett watchers - those of a more hard-nosed persuasion - argue that, at roughly 20 times profits and a 30% premium to BNI’s share price, Warren is paying far too much to get this deal done. Worse still, he is ponying up for the fully valued railroad shares with not just cash, but a big chunk of cheap Berkshire stock.

This certainly does not feel like a classic Buffett deal. He is known for buying high-quality assets at a sharp discount to intrinsic value, not paying fat premiums.

If one looks at the publicly stated reasons for the BNI buy, the move is a bit of a head-scratcher. But if one considers the hidden, unstated reasons, Buffett’s railroad love affair makes more sense.

The Long Goodbye

The purchase of a major railroad does at least one big important thing for Buffett. It takes Berkshire Hathaway a major step closer to being “idiot proof.”

There has been plenty of conjecture over the years as to who Buffett’s successor might be. Buffett no doubt has confidence in his front-runner, David Sokol - the current head of Mid-America Energy, Berkshire’s utility business, and NetJets, an aviation business - but not that much confidence.

Depleting Berkshire’s cash hoard to buy a railroad that more or less runs itself will give Buffett’s successor far fewer decisions to make. That means less opportunity to wheel and deal… and less chance of screwing things up.

“It’s kind of like dumbing down the asset base,” hedge fund manager and long-time Buffett watcher Jeff Matthews opines. “It suggests that the long-term opportunities have changed, and going forward Berkshire is not much more than a general call on the American economy, whereas in the past it was a call on Buffett’s investment acumen.”

Doug Kass, another Buffett watcher who has made money on both the long and short side of Berkshire Hathaway shares, points out that this will probably be the last big deal that Buffett ever makes. At 79 years old, the Oracle may feel time pressing in on him.

A Fitting Capstone

The purchase also makes sense in terms of a long, historical arc reflecting Buffett’s life and times as an investor.

In the beginning Buffett was well and truly an “investor’s investor”… hunting for “cigar butts,” poring over balance sheets, and even driving around the country to buy up odd-lot batches of stock certificates from befuddled holders who didn’t realize their true worth.

In the first half of his career, in other words, Buffett proved himself a master at uncovering bedraggled and forgotten gems. But in the second half of his career, Berkshire became so big and unwieldy that Buffett was forced to adopt the mantra of “a wonderful company at a fair price.”

One of Buffett’s true master strokes was buying GEICO, the insurance company, in order to take advantage of “float” - the cash flow created by insurance premiums that don’t have to be paid back right away. Meanwhile, as Berkshire itself grew larger and larger, the Buffett empire started looking less and less like a house of value… and more like a sprawling industrial conglomerate.

Berkshire has also grown ever more a creature of connections, regulations and handouts. In a sign of the times, Rolfe Winkler of Reuters points out that eight Buffett-owned companies have received more than $100 billion in government bailout funds.

So it would make sense, then, for the BNI railroad deal to be a sort of capstone… a sign that Berkshire’s transformation from virtuoso investing vehicle to major league mega-conglomerate is all but complete.

The switch is also marked by Buffett’s decision to finally reduce Berkshire’s share price. By splitting Class B common stock of Berkshire at a 50-to-1 ratio, Buffett both makes the shares available to a far wider range of investors and increases the odds of Berkshire becoming an S&P 500 name.

“A Hedge Against Folly”

If one had to sum up the BNI purchase in four words, they might be these: “A hedge against folly.”

Not just folly on the part of Buffett’s successor, but folly on the part of the U.S. government as well.

A railroad with monopoly-like pricing, it turns out, can be a great hedge against inflation. If the global economy continues to recover, and emerging market demand for things like energy, grains and metals continues to rise, then America’s premier railroad network should see outsized benefit. If America continues to wither as a manufacturing power relative to Asia, the railroads could also benefit as more goods arrive via U.S. coastal ports. (Someone has to trek all those goods through the heartland.)

In a truly ugly economic scenario, though, railroad ownership could still make sense. This is because, if things get bad enough, government response will more than likely spur a true U.S. dollar crisis, causing the value of hard assets to skyrocket. Peak oil, too, is a potential looming concern as the cost of energy and fuel maintains a long-term uptrend. A railroad can be a solid hedge against all these things.

If the U.S. economy were again to stall or slow dramatically, profits would be hit hard and the BNI buy would no doubt be second-guessed. But the railroad would still survive, and still have a shot at thriving longer term, on the ability to extract monopoly-style rents on ever more expensive cargo shipments. Plus the only major transport alternative to railroads is trucking - and if the cost of fuel again doubles or triples, railroads will look that much better.

All in all, the purchase is not classic Buffett. It isn’t hard to make a case he got too excited and overpaid - a mortal sin from the hard-core value investing perspective. But in light of the long-term Buffett legacy, the desire to hedge against folly, and Berkshire Hathaway’s twilight days as a premier investment vehicle, the BNI deal makes sense.

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