Buffett's Train Bet Could Knock Berkshire's Shares Off-Track - 11/04/09

Buffett's Train Bet Could Knock Berkshire's Shares Off-Track
11/4/2009 8:54 AM EST

QuickTake
Update BRK.A BNI GS

 

Given his age and the size and scope of the deal, this is likely the last meaningful bet that Warren Buffett will make.
Some elements of yesterday's Burlington Northern acquisition go against some of Warren Buffett's previous tenets.
Investors may begin to value Berkshire more like a closed-end fund and less like a prized possession.

 

To date, Dexter is the worst deal that I've made. But I'll make more mistakes in the future -- you can bet on that. A line from Bobby Bare's country song explains what too often happens with acquisitions: "I've never gone to bed with an ugly woman, but I've sure woke up with a few."

-- Warren Buffett, Berkshire Hathaway Letter to Shareholders (2008)

I always qualify my Berkshire Hathaway (BRK.A) observations, especially when there is some criticism or questioning of strategy involved, by saying that I literally worship the Oracle's body of work, his unprecedented investment success ... and his wealth!

In the past, I have shorted Berkshire when I thought Warren lost his groove, and I have gone long Berkshire when the market was in a state of panic -- both times profitably. I have criticized what I have seen as style drift when he increased his involvement in derivatives (or financial weapons of mass destruction) and I have parodied his high-profile editorial in The New York Times in October 2008, "Buy American. I Am."

Unquestionably there will never be another Warren Buffett, and yesterday's deal will not be a "train wreck," but elements of yesterday's Burlington Northern Santa Fe (BNI) acquisition go against some of his previous tenets and a deeper dive into the Burlington Northern deal and its ramifications are suggested below:

  • Not Ben Graham-Like. Unlike the Goldman Sachs (GS) transaction and a number of other timely deals over the past year, in which Buffett extracted blood through hefty warrants issuance, Buffett paid up for Burlington Northern (a 30%-plus premium), and he paid a full price of about 20 times earnings.

     

  • Offering Berkshire Stock. A hefty portion of the acquisition of Burlington Northern was funded by exchanging Berkshire Hathaway stock. While Buffett has in the past held his equity dear and has criticized himself (see quote at beginning of today's opening missive) for how expensive early stock acquisitions were, Burlington Northern is no Dexter Shoe.

     

  • Stock Split. To accommodate the large portion of the exchange of stock, he split Berkshire Hathaway's shares 50-1. Splitting his shares is something he previously cautioned against ever doing. Though the company introduced a lower priced Class B share in 1996, in a letter to Berkshire shareholders in 1983, Buffett stated that investors should be "focused on business results, not market prices." He wanted owners, not renters, in his stock, but the split is likely to result in an intrusion of renters and in great fluctuations in Berkshire's shares.

     

  • Berkshire's Cash Hoard Is Now Materially Depleted. This closes the bullish chapter during which Buffett, through a series of well-timed and well-priced deals, had converted a low-yielding $45 billion-plus cash position into accretive and higher earnings yields through portfolio acquisitions. For the time being, there is little more that can be done to buoy Berkshire's returns; it's now up to the world's economies.

One of the clear positives to yesterday's announcement is that Berkshire's shares will become more liquid, and an entry into the S&P 500 now seems inevitable. That said, it should be emphasized that a steady supply of stock will counter the better liquidity offered up through a split and lower share price. The Bill and Melinda Gates Foundation will likely accommodate the renewed interest by stepping up their sales of Berkshire Hathaway stock. As it has previously announced, the Gates Foundation has been selling at a steady pace; the Foundation sold approximately 17,000 "B" shares that in each of the last several months.

On to the negative side of the ledger, given his age (and the growing possibility that Buffett might hand over running Berkshire to his successor sooner than later), the size of the Burlington Northern deal relative to Berkshire's cash position and the scope of the deal (and the need to consolidate Burlington Northern's operations into Berkshire), this is likely the last meaningful deal that Warren Buffett will make.

My conclusion?

As there arguably still remains a Buffett share price "premium," I would now make the case that the interaction of the above factors will lead investors to valuing Berkshire Hathaway more like a closed-end fund (selling at a discount to its underlying or "intrinsic value") and less as the premium and prized possession that it has been over the past 40-plus years.