Warren Buffett Lied to You about Railroads

by JT McGee

Railroads make great value investments.During the worst of the downturn, I remember pulling my Wall Street journal out of its yellow rain protection bag thing only to see Warren’s billionaire grin on page A1.

The headline read of Buffett’s acquisition of Burlington Northern Sante Fe, which Buffett happily declared to be an “all-in wager on the economic future of the United States.”

He was lying.

In very simple terms, railroads are the classic case for value investing; they’re difficult to build, impossibly efficient, and extremely resilient to economic downturn.

A Perfect “Moat”

Buffett compares his investments to castles. When he invests in something, he says he wants a really big castle, but most importantly, he wants a really big, deep, and wide moat around it. So what does he see in BNSF?

A blog post at FT says the following about railroads: (summarized)

  • Trains can move a ton of freight 470 miles on a single gallon of diesel whereas tractor-trailers manage only 130.
  • Trains can carry the same amount of freight as 280 trucks. Impressive, sure, but especially impressive when you consider that every truck needs a driver, and only a few people work on a modern locomotive.
  • No new railroads are being constructed, and 40% of all railways in existence in the 1980s are no longer used.

The points about efficiency speak for themselves; railroads have a very clear competitive advantage. Tack on the decline in usable railway and the rise of the American consumption economy and we have a very clear winner!

Transportation this, transportation that

Everyone is telling me that I need to have more exposure to transportation in my portfolio. In most of these articles, I’m being sold on the idea that I should buy into dry bulk shipping companies, as they are sure to see rising profits as the world economy rebounds. I think that view is foolish, to say the least.

To show the failure in such a simple view, I’ve enlisted the help of the Department of Transportation. They maintain a website that shows “marine highways” or the waterways that move through and around the United States that are most conducive to the transport of goods.

Here’s one of their graphics:

marine highways, bulk dry shipping companies vs railroads

Where's your moat if your competitors have boats?

If you look at the above picture, you’ll see a map of marine highways—I call them rivers—that run through the United States. But if you pay more attention to the map, you’ll realize that there’s far more to it than just the rivers. Look all around the United States—that’s what we like to call the ocean!

The reality is that dry bulk and container shippers have zero structural advantages in shipping goods over water. (Read more about structural advantage in a post about Monopoly.) Following the 2000’s boom, shipping companies ordered ships in record amounts because they could. You can fit unlimited ships on the ocean surface, but you can’t fit unlimited trains on railway tracks.

In further exploring the DOT website, I found the agency’s map of railways:

A map of railways in the United States

Notice how few railroads there are, and how limited the possibilities are for future expansion. Consider the following:

  • The difficulty in building a new railway knowing how many homeowners, business owners, and farmers live between points A and B. (Pick your own points A and B).
  • How much time and money it would take to force an eminent domain through court to start construction of new railways.
  • Mountains.
  • The capital investment railroads require.

Those four difficulties are the best moat you’ve ever found in a business in your whole life. You’ll truly never find one like it.

How Buffett Lied

The reality is that the American economy did not need to experience a revival for railroads to make sense. Buffett doubled down on railroads because they make way too much sense. To purchase railroad securities is to say to the markets, “Hey, I bet you that Americans either import stuff from other countries or export stuff to other countries in the future.” That’s a pretty sure bet.

But Buffett doesn’t just buy any railroad. He’s not just some ETF guy who wants the whole industry at any cost; no, Buffett’s going to pick the right industry, and also the right company in that industry.

Examine this map of BNSF’s active railways:

A map of Burlington Northern Sante Fe railways in the US.

This map, compiled and released into the public domain by Wikipedia’s nerd army, shows how much of a stranglehold BNSF has on railway shipping. The red lines are railway in which BNSF has trackage rights, rights which entitle it to ownership of the railway. The pink lines are those on which it can ship its goods through another railway company, using the other company’s trains.

I’m going to bring back the old chart, which shows all American railway in service:

A map of railways in the United States

In comparing the two, it becomes obvious that BNSF owns every piece of worthwhile railway in the United States. It has exposure to every single western port, every entry into Canada excluding only New England, and virtually every port in the Gulf of Mexico.

Whether or not the US economy recovered after the global financial crisis was really a moot point. Not only was BNSF perfectly positioned to profit on any minute uptick in low-cost shipping, but it’s also protected even if the US economy stagnates. If we were to revert to an entirely agriculture and manufacturing economy, BNSF would still have just as much stuff to ship. This time, though, the trains would be heading out from the American Midwest, rather than in from the sea ports.

Buffett Knew It

I think many passive and active investors alike get the wrong idea about Buffett. Yeah, the guy is good, I’m not going to say he isn’t, but he’s also very good at speaking so simply that he almost sounds like an idiot.

Imagine that tomorrow one of your friends came up to you and said, “Hey, I’m killing the broad market; I’ve generated annual returns of 34% for the past 10 years.”

You’d probably ask, “How?”

And he or she would reply, “I just buy good companies for really cheap.” Or even worse, “I just try to never lose.” Oh boy…

In essence, that is Buffett’s philosophy, and those words easily summarize his investing thesis. But when you really look at why Buffett is buying company X, his purchase is rarely fixated on the balance sheet, or even the company’s plainly obvious discount to its peers. Instead, it has to do with all the other information that you and I could find quite easily, but would never pay attention to.

Classic examples:

  • Coca-Cola – A major Berkshire Hathaway holding, Buffett saw what everyone else could have: Americans actually prefer the taste of Pepsi, but Coke outsells them nearly 2:1. Pepsi is sweeter, but Coke’s brand pulls on their heartstrings.
  • GEICO – Insurance is a commodity. To compete with a commodity, you have to sell on price. Nobody does this better than GEICO, which is branded as the low-cost auto insurance provider. If the economy tanks, there are fewer people seeking cars, but more people seeking low cost auto insurance. If the economy roars, the low-income demographic starts buying cars, and GEICO’s low cost insurance.
  • BNSF – Shipping is a commodity. If you need to ship from one end of the country to another inexpensively, then you have to use BNSF railways. If you need to move product from Mexico to Canada, you use BNSF. If the US economy stops importing stuff, then we start exporting stuff. If the US economy tanks, then we revert to manufacturing and agriculture, two industries that rely heavily on railway shipping. If the US economy roars from high-paying service employment, then we start importing stuff from Asia, which invariably lands on Pacific seaports connected to BNSF railway.

I won’t hesitate to say that it was BNSF’s railway, not their balance sheet (okay, maybe a little of the balance sheet) that sold Buffett on buying the rest of the company at a discount. He can call it a bet on the economy all he wants, but it was really just a bet on normalcy—and 99.9% of the time, things are pretty darn normal.

Photo by: ELETOH

{ 17 comments… read them below or add one }

Hunter May 23, 2011 at 16:55

I agree, this was a super smart investment, for all of the reasons that you point out. However, I think it’s also a sign that Buffet sees sharply steeper energy prices in the future. Railroads are efficient, and will attract future business by virtue of the fact that alternatives will become less competitive.

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JT McGee May 23, 2011 at 17:19

Yes, definitely. I see railroads as a diversified play on rising energy prices just like Chevron, which is a integrated oil company, is a diversified play on rising energy. Railroads get a positive over oil companies in that the possibility of cap and trade would affect oil producers negatively, whereas it would affect railroads positively.

That’s another tally for railroads vs. bulk dry shipping companies. If the cost of transportation rises too high due to oil, foreign exports into the United States are at a competitive disadvantage. So domestic production fires up, and railways end up shipping just as much product, regardless of whether or not it is stamped “Made in China” or “Made in the USA.”

I love this boring business, but I’m not in love with its current multiple. I can wait for another recession. :D

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Hunter May 24, 2011 at 09:17

Ha! Be careful what you wish for.

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Jeff @ Sustainable life blog May 24, 2011 at 14:26

I think the railroads were a great investment, and he probably had his eye on them for quite some time, he just waited to get a really low price on them. He probably knew the default swaps were going to blow up, just not when. As they say, cash is king!
I’d like to buy into a railroad when I get the money!

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JT May 24, 2011 at 19:07

Probably so. If there’s one thing Buffett is good at, it’s being patient.

He’s supposedly sucking a nice fat $6-8 billion haul out of this company, which is a pretty spectacular cash on cash return. He only took on a moderate amount of leverage to do the deal, but sheesh…ignoring his previous cost basis, he’s not doing too bad.

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Invest It Wisely May 24, 2011 at 21:01

Nice analysis! If oil prices continue to rise then railways continue to look good, as they will relatively be more attractive than long-haul trucking.

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JT McGee May 25, 2011 at 00:43

Yep. Plus, there’s plenty of space in the open ocean for marine shippers, and virtually limitless amounts of highways for long-haul trucking. Railroads? Not so much. I love this industry.

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Buck Inspire May 26, 2011 at 16:48

Awesome analysis JT! Clear and easy to understand. Are you a financial analyst or someone who works in the transportation industry? Great detailed breakdown. Look forward to more.

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JT May 26, 2011 at 17:10

Glad you liked it.

I’d like to work in finance as an analyst. Long-term goal is to earn my CFA. Until then, I’m just an undeclared (F— prereqs, basically) finance major who wanted an outlet to talk about finance/business. So I started a blog. I work in marketing.

I need to make my disclaimer bigger. LOL.

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Travis@TradeTechSports May 28, 2011 at 12:16

Ya Buffet isn’t an idiot…he knows what he is doing regardless of what he tells the public. He just made $5 billion on a Goldman Sachs “loan” also…he knows how to buy when there is blood in the streets. But that’s a bit easier to do when you are one of the richest dudes in the world.

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JT McGee May 28, 2011 at 13:56

Yes, that’s definitely true. I guess losing 50% of your portfolio doesn’t really mean anything if you still have $20 billion left over. That GS loan was brilliant, and his structuring of it–interest plus stock warrants–should provide all of us with a great lesson.

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Eric January 25, 2012 at 16:40

I am a BRK.B shareholder and have been to two annual shareholder meetings. I have followed BRK news and made a lot of money with them for both myself and my former university’s endowment.

I think your criticism of Buffet speaking simply is one of the reasons he is so successful. He knows how to value a company, knows how to interpret a balance sheet, and knows how to read an income statement. He recognizes strong book value per share and a value when it exists. He also only buys companies where he can understand the business model. That means no tech companies (for the most part).

That is what leads to the success. He is patient and buys what he understands. If we all did that, and looked for value over sexy stocks, we might all do a bit better.

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JT McGee January 25, 2012 at 17:14

I didn’t mean to be a Buffett critic at all. I’m just saying that because he speaks so simply, people miss what really motivates him to invest. He speaks so simply that people miss the big picture for Buffett’s simplification of his investment strategy. There are countless so-called “value investors” who, because of Buffett’s statements about buying companies cheap, will buy anything on a pure P/B ratio. That’s nonsense – and not at all the Buffett methodology, though it is what he tends to broadcast by what he says.

As a value investor, I agree entirely with your last statement.

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Daniel Milstein January 29, 2012 at 06:33

That is true,Lee. As an author and business man, I can relate to how you said, “Imagine that tomorrow one of your friends came up to you and said, “Hey, I’m killing the broad market; I’ve generated annual returns of 34% for the past 10 years”". I hope more people discover your blog because you really know what you’re talking about. Can’t wait to read more from you!

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Wayne @ Young Family Finance January 29, 2012 at 07:23

Great Post! I’ve always wanted to see a Warren Buffet investment deconstructed.

In general, I’d think that railroads are a horrible investment, but as you pointed out there were obvious tactical strategies that made that investment make sense. That’s why Buffet is the billionaire.

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Car Negotation Coach January 29, 2012 at 09:36

JT- Excellent breakdown! I’m actually pretty clueless about our country’s transportation system aside from the fact that I’m aware it’s pretty difficult to get from point A to point B using a train.

Perhaps the expansion secret lies not in building more rail lines, but instead, building a new innovative form of bulk transport that can piggy back on the interstate system without adding much congestion. i.e. not more trucks.

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Darwin's Money January 29, 2012 at 22:44

If I recall, his GS play turned out ok with that yield and warrants too. Thing is, in recent years, Berkshire Hathaway hasn’t done all that great as I recall. It seems like he gets credit for all the prescient moves but isn’t exactly lighting it on fire.

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