MP173 wrote: 1. Explain your comments on risk and profitability. I have read them several times and rather than comment on it, I ask for clarification.
1. Explain your comments on risk and profitability. I have read them several times and rather than comment on it, I ask for clarification.
Looking at the example.
RR # 1. Operating expenses of $500 earns $50 profit, 10% rate of return on sales.
RR #2. Operating expenses of $1,000, earns $75 profit, 7.5% rate of return on sales.
RR # 1 is more profitable. RR #2 earns more profit.
Suppose each RR has $500 of equity capital invested. ROE RR# 1 is 10%, 10% return on sales. ROE RR# 2 is 15.0%, 7.5% return on sales.
As shown in the earlier post above, RR #2 has a greater risk of loss.
Here's why, and particularly regarding that part of the picture that most often reflects any given ROE: debt. ROE can be purchased. It has nothing to do with the performance of the company. You don't like the 15% ROE for RR #2, let's increase it.
RR # 2 decides to increase its ROE, to increase its stock price, say, because its officers have some option shares, and would like to maximize their returns. The RR decides to purchase $250 of equity, creating a RR capitalized at $250 equity and $250 debt. That's great if you are selling your option shares to the company; $250 goes to those shares.
But the following year, RR # 2 incurs interest charges of $25 because of its 50/50 debt to equity ratio (at 10% interest). Costs increase to $1025, and profit drops from $75 to $50, profitability drops to 4.9% return on sales, even though its ROE is now 20%.
RR #2 is earning the identical "profit" of $50 now as RR # 1; it has purchased a substantial increase in ROE, but RR # 1 still generates a 10% rate of return on sales; RR #2's profitability has declined from 7.5% to 4.9%.
Is the company, RR # 2, stronger or weaker than it was before?
ROE suggests it is stronger; profitability suggests it is weaker. Which is more accurate?
Now, this is where the "risk" factor comes in.
Both railroads are subject to the same environmental factors -- general economic conditions beyond the control of management. RR #2 earned more "profit" than RR #1, decided to take some of that profit and purchase shares, and now has a positively glowing ROE, even with reduced income because of added debt.
But, its profitability has been lower, because it's management manages poorly compared to RR #1 and we know that from the "profitability" measure. The profitability metric measures the risk. Notwthstanding its higher profits and higher ROE, its lower profitability measures the ability of that management and provides the most accurate comparison of the two managements. Here's the risk:
A price increase in supplies increases costs by 5%, and the market does not permit the costs to be passed through.
RR # 1's operating costs are now $525, RR # 2's costs are $1,075 ($1050 + $25 interest for debt). RR # 1's profit drops from $50 to $25, it has a 5% return on sales, and its ROE drops from 10% to 5%. RR #2 profits drop from $50 to $0. It's rate of return on sales is 0%, and it's ROE drops from 20% to 0%.
RR #2 has no profit, nothing to re-invest in the company, nothing to hand out in dividends. It will have to borrow again to satisfy one or more of those needs. It's costs will be accordingly higher the next year because of that.
RR # 2 has gone from a 20% ROE to 0% ROE, while RR #1 went from 10% ROE to 5% ROE, and retains profits to re-invest and or pass through in dividends. It will have no additional costs to contend with next year.
That is why RR #2, with the higher ROE, represented the greater risk, when measured by the profitability metric, because RR #2 was, ultimately a less profitable company, and ROE actually was an inverse indicator of that weakness. That is, ultimately, the "profitability" of 10% compared to 7.5% was far more important in gauging the relative strength of these two companies than either the total profit ($50 vs $75) or the ROE (10% vs 15%), and particularly when assessed against the process by which ROE is typically improved - substituting debt for equity.
Wow! Quite a bit of thinking in this thread! Intersting stuff.
I must say I was pleased when I looked at our portfolios yesterday morning and saw my Burlington Northern Santa Fe stock price. I think the big railroads are still good investments for the long run. Even after the increased price yeserday, BNI's P/E is still at a comfortable level. Also, I'm convinced that railroads will continue taking market share from trucking in the years ahead due to fuel efficiencies.
GARRY
HEARTLAND DIVISION, CB&Q RR
EVERYWHERE LOST; WE HUSTLE OUR CABOOSE FOR YOU
MP173 wrote: 5. I do not think Buffett purchased BNSF and others due to the increased profit margins during the downturn. I think he purchased it solely on the belief that it will be a wise investment. Many books have been written on Buffett's methodology and I have read several. Basically Buffett's investing philosophy boils down to this. Determine the value of a business and then buy only when that business is selling at a significant discount to it's value (The Warren Buffett Way, Robert G. Hagstrom, pp 122). Buffett has made a determination that BNSF was under valued and made a significant purchase. He also believes that BNSF is a better investment at the time he purchased it than other companies he owns (either outright or in major stock holdings). Based on his tenet of buying and holding for the long run, he believes BNSF is a value. I would believe that is because of future earnings rather than a downturn in business. After all, the downturn in business will at some point turn around.
5. I do not think Buffett purchased BNSF and others due to the increased profit margins during the downturn. I think he purchased it solely on the belief that it will be a wise investment. Many books have been written on Buffett's methodology and I have read several. Basically Buffett's investing philosophy boils down to this. Determine the value of a business and then buy only when that business is selling at a significant discount to it's value (The Warren Buffett Way, Robert G. Hagstrom, pp 122). Buffett has made a determination that BNSF was under valued and made a significant purchase. He also believes that BNSF is a better investment at the time he purchased it than other companies he owns (either outright or in major stock holdings). Based on his tenet of buying and holding for the long run, he believes BNSF is a value. I would believe that is because of future earnings rather than a downturn in business. After all, the downturn in business will at some point turn around.
Well, it is certainly interesting. It seems like buying at the bottom of a business cycle represents the opportunity, rather than at the top of a business cycle. BH has a ton of cash -- that is the normal business cycle strategy when an investor thinks the cycle is about to break -- to be able to maximize value by cashing out at the top, and then to have the cash to buy stocks in good companies when they are cheap again. Something else is going on here...
OK here's why I think Buffet bought into BNSF.
1) The railroad serves the Powder River Basin and there is no end in sight.
2) The railroad serves every major Pacific port in the US and it rolls long trains of containers a long way. And there is no end in sight.
3) The railroad has increased its capacity in the right places so it can grow.
Its become a money machine.
Here's not the reason Buffet bought into BNSF.
1) Business is going to decline. It might go down short term, but Buffet isn't a short term guy.
I see your point and have to agree that any assumption of debt on a balance sheet will in fact add to risk of the company. In fact any investment other than treasuries will incur risk (US Treasuries are deemed a risk free investment).
Risk is not a bad thing. In fact it a determining factor on the return of an investment. The proper capital structure is a never ending debate not only within a company, but also within families (check out the default rates on sub prime mortgages these days!).
Railroad #2 is more typical in the industry. Most railroads have about a 50% debt to equity ratio. I will check on this tomorrow when I have more time and report back with the class 1's. Due to the capital intensive nature of the industry, often sales/assets are only about .5, so a leveraged capital structure is necessary to attract capital.
Both Railroad 1 and 2 seem to have a much higher sales/asset ratio (we havent included current assets and liabilities in the mix, so we really dont know what the amount of assets are).
It would be interesting to check your theory in the real world of railroading, but I know of no rails with no debt.
I will agree tho that Railroad 2 carries more risk...more on this tomorrow as I am exhausted.
ed
MP173 wrote: Risk is not a bad thing.
Risk is not a bad thing.
Risk is the price of reward, although profitability also measures management quality, whereas I don't think ROE does.
The example is solely to illustrate the risk. In the real world there a well-defined formulations of debt to equity ratios that maximize return and minimize risk, and the example was not designed to suggest that no debt is a perfect condition; but rather simplified the presentation of relative conditions by using one as a zero condition -- zero offering an easier relative conceptualization than, say "corporation # 1 has $3.2 billion in debt, while # 2 has $4.6 billion in debt ...".
Michael:After a solid 8 hours of sleep I went back and re-read the past few posts. I agree with your statement on risk. We both know what that leverage on rr#2 would produce if the volume was increasing....so there is no need to hash and rehash it.
Greyhound, I think you pretty much summarized it pretty well. BNSF seems to be sitting in a pretty good spot right now, when compared to the other railroads. It can be said that BNSF is much more of a play on both Asia and energy than UP. Plus throw in their sizeable grain business, which has suddenly become another play on energy, and you have a company poised to grow and increase margins.
Now, I wonder which other rails BH purchased?
I spent the last hour putting together a spreadsheet on class 1 data.
From a financial view, NS makes sense, but a more compelling case could be made for CN. Their returns on assets and equities pretty are better than NS and were better in 04 and 05 than BNSF.
2004 2005 2006
CN return on assets 5.2 6.8 unavailable
NS return on assets 3.7 5.0 5.1
BNSF return on assets 2.7 5.1 6.0
CN ROE 12.5 16.3 ua
NS ROE 11.6 13.8 13.5
BNSF ROE 8.5 16.1 18.2
CN Operating margin 33.1 36.2 ua
NS Operating margin 23.3 24.8 27.2
BNSF Operating margin 15.4 22.5 23.5
From a valuation standpoint tho, CN is a stretch. It currently has a market cap of over $50 billion on revenues of $6 billion. It seems overvalued at this time. BNSF's market cap is $31billion with $15 billion in revenues and NS is $21billion market cap with $9 billion in revenue. However...I am not sure if CN's marketcap and revenue is $C or US. Will check on it.
If the final round of mergers did occur...and I doubt it will, a combination of BNSF,NS, and CN would be extremely effecient, provided they could all get along (a big if).
One other interesting piece of info...employees per mile. BNSF has 1.14, UP has 1.4, NS has 1.35, CSX a whopping 1.70, CN has 1.14 and CP has 1.15. Granted that is not necessarily a great indicator, as traffic density would be a factor and the Canadian lines do not seem to have the density (nor the revenue per mile) as the US carriers, but CSX and UP seem a bit out of line.
edbenton wrote: They have some major plusses for them 1 Shortest L.A to Chicago route the former SF transcon. 2 the Powder river need I say more. 3 All the grain they haul with all the ethanol and biodiesel palnts being built here in the midwest grain shipping will be needed. 4 Strong leadership that right ther is the key.
Didn't these plusses exist, in substantial part, several years ago? From the standpoint of these plusses, wouldn't it have made sense to buy them at 35 -- if indeed these factors are the motive -- rather than wait until 85?
I mean, the reasons offered on this thread strike me as raising more questions than answers. Warren Buffett just figured out that BNSF serves the Powder River Basin? That it has a line from Chicago to LA? The Sage of Omaha just now looked at a map and discovered that "the railroad serves every major Pacific port in the US and it rolls long trains of containers a long way"?
I don't think he got where he is by being the last guy on the block to notice the obvious. Something else is driving this.
Energy and manufacturing are driving this.
Energy pricing will fluxuate, but the manufacturing has changed dramatically. He understands that. Go back to the original Berkshire Hathaway company. It was a New England textile manufacturer with assets but a declining market. He bought it and used the assets to move forward.
To think that the energy pricing is only going to go up is dangerous. We go thru these trends about every 10 - 15 years, but the manufacturing has left. It has to be transported. There are only so many methods of doing that.
Remember that BH is involved in transportation. They own XTRA Lease.
MP173 wrote: Energy and manufacturing are driving this.Energy pricing will fluxuate, but the manufacturing has changed dramatically. He understands that.
Energy pricing will fluxuate, but the manufacturing has changed dramatically. He understands that.
Well, he didn't just get the revelation on those items last week, when BNSF stock was at all time high.
And if he did just get that revelation last week .... well, ...
I repeat, the "obvious" is not an explanation, because they were just as "obvious" two years ago, four years ago, take your pick, when the stock was a lot cheaper.
If he had announced last week that he was buying BNSF because he just discovered that energy prices are going to change, and that manufacturing has changed dramatically, or that he just looked at a map and discovered that the BNSF served West Coast ports, and that he didn't know that before, I think people would have started to worry about Warren ...
Buffett didn't get his reputation by being the last guy on the block to notice the obvious.
MichaelSol wrote: I don't think he got where he is by being the last guy on the block to notice the obvious. Something else is driving this.
Thanks to Chris / CopCarSS for my avatar.
We dont know when he started buying adn at what price....do we? I havent really checked into this other than reading on this forum. Do we know how many shares and total price paid for an average cost per share?
I will see if I can find it.
Murphy Siding wrote: What would you think is driving this?
Warren Buffett quote: - "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
Wasn't Berkshire one of the companies that bought part of EMD?
MP173 wrote: We dont know when he started buying adn at what price....do we? I havent really checked into this other than reading on this forum. Do we know how many shares and total price paid for an average cost per share? I will see if I can find it.ed
Just a guess, but I imagine that last year, when BNSF was trending down, got to below 60, then started its current strong move upward.
BH made it's last purchases on April 4th and 5th to push it over 10% holdings and triggered the filings:
4-4-07 417,900 shares @ $81.81
4-4-07 10,000 shares @ $81.72
4-5-07 1,219,000 shares @ $81.18
The total shares held by BH's three insurance subsidiaries (National Indemnity, National Fire and Marine, and Columbia Insurance) totals 39,027,000.
Looking at the price history, BNSF said goodbye to the $60's in late September and moved around quite a bit in the $70's, closing above $80 on October 16th. Since the first of the year it has been moving very very steadily from the $73 range up to the low to mid $80's before the announcement.
BH has been accumulating for awhile and has been very steady since the first of the year, probably earlier than that.
edbenton wrote:Hathaway is a 50% owner of EMD so maybe more SD 70ACe's are in the future and also maybe some straight SD70M-2 also. Hey you have to keep your largest shareholder happy right.
Well, that was my thought. Any substantial order for locos, is HUGE money. So, by placing himself on both ends of such a transaction, he pretty much gets to write his own ticket. Plus take any gain on the ownership of the BNSF stock that would happen regardless.
Not the same company, EMD is part owned by Berkshire Partners. Look at their website.
Berkshire Partners
Murphy Siding wrote: MichaelSol wrote: I don't think he got where he is by being the last guy on the block to notice the obvious. Something else is driving this. What would you think is driving this?
Well, looking at BH's cash position over the last decade, there is an interesting pattern. They seem to have been pretty heavily invested at the time of the dotcom boom, and then began to convert to cash 3-4 years ago. Now, going into cash before the stock market really takes off is not exactly good timing. You miss the appreciation in stock that presumably was the reason you bought stock in the first place.
Then, his vaunted position in Coca Cola occurred during a time when Coke began to crumble -- it's historic primacy over Pepsico disintegrated -- Pepsico is now the king of the hill, and Buffett resigned from the Coca Cola board -- one of the few he took an active role in. Good call, bad call?
Then, to be sitting on piles and piles of cash for three years or more, while interest rates are at historic lows is also not exactly "textbook" portfolio management; all the while watching good companies throw off cash and stock appreciation right and left.
Then to move on railroad stock at a historic high at a point in time when it actually makes sense to move into cash, according to Buffett's own past track record -- well, it all amounts to an interesting spectacle. We are coming to the end of a business cycle. But, we are not there yet. There would be plenty of time and opportunity to buy good railroad stock at lower prices. No need to get in a rush, at this particular point in time. And there was plenty of time to buy this stock earlier -- at far lower prices.
That huge cash pile meant Buffett expected something much earlier, and it obviously didn't happen. Oh well, no one cries when they still have $40 billion in the bank. But, he's moving very little into stocks -- the railroad play is a drop in the bucket.
MichaelSol wrote: Bob-Fryml wrote: Perhaps a little birdie landed on Mr. Buffett's shoulder and pointed out the explosion in capacity that's on the verge of happening once BNSF completes double tracking the remaining small segments of the Chicago - Los Angeles mainline. Freed of its greatest bottlenecks, the entire line is poised to benefit and the BNSF will be in an extraordinary position to complete for any business that moves two thirds or more of the way across the continent. Well, the old argument used to be that capacity caused prices to fall, and constrained capacity caused prices to rise. Now, with a hugely expensive capacity expansion, coming fully available at just about the time as traffic should begin to decline as a result of the normally expected business cycle, doesn't this particular scenario suggest that something different would happen? The idea of "an extraordinary position to compete" is suggestive to me .... even as costs of operation and paying off the new investment will necessarily be higher ... compelling the need to get the business ... compelling the usual cost-cutting to fill the lanes ....This angle just doesn't fit too well, if the premise is that Buffett is taking into account the downside of a business cycle, which judging by the BH cash position, suggests that he is ....
Bob-Fryml wrote: Perhaps a little birdie landed on Mr. Buffett's shoulder and pointed out the explosion in capacity that's on the verge of happening once BNSF completes double tracking the remaining small segments of the Chicago - Los Angeles mainline. Freed of its greatest bottlenecks, the entire line is poised to benefit and the BNSF will be in an extraordinary position to complete for any business that moves two thirds or more of the way across the continent.
Perhaps a little birdie landed on Mr. Buffett's shoulder and pointed out the explosion in capacity that's on the verge of happening once BNSF completes double tracking the remaining small segments of the Chicago - Los Angeles mainline. Freed of its greatest bottlenecks, the entire line is poised to benefit and the BNSF will be in an extraordinary position to complete for any business that moves two thirds or more of the way across the continent.
Well, the old argument used to be that capacity caused prices to fall, and constrained capacity caused prices to rise. Now, with a hugely expensive capacity expansion, coming fully available at just about the time as traffic should begin to decline as a result of the normally expected business cycle, doesn't this particular scenario suggest that something different would happen? The idea of "an extraordinary position to compete" is suggestive to me .... even as costs of operation and paying off the new investment will necessarily be higher ... compelling the need to get the business ... compelling the usual cost-cutting to fill the lanes ....
This angle just doesn't fit too well, if the premise is that Buffett is taking into account the downside of a business cycle, which judging by the BH cash position, suggests that he is ....
"Well, the old argument used to be that capacity caused prices to fall, and constrained capacity caused prices to rise." is very true.
But there's another variable in play here as well. Yes, there probably will be some drop off in traffic as the business cycle cools; but with the opening of the last segments of Chicago - Los Angeles double track corridor, BNSF will begin to enjoy
Delayed train expenses include ...
When BNSF realizes a smoother operation due to the elimination of capacity restraints, they will be producing a more attractive, service reliable product that customers will be more willing to use.
Railroad managers are motivated to invest in capacity improvements as a means of eliminating recurring and painfully costly bottlenecks. In those corridors that are also experiencing traffic growth, this activity becomes even more important. With each additional mile of double track built or CTC installed, the operation, as it impacts all trains, becomes a little better. Velocity improves; locomotive, car, and crew utilization gets better; the kind of service reliability that customers crave becomes more consistent; but, that doesn't automatically mean that market forces are going to punish a railroad with lower freight rates. In today's transportation environment I just don't see where an improving and more attractive operation has to result in a lock-step decrease in freight rates,
Yes with a business cycle downturn there probably will be some downward pressure on freight rates, but if the BNSF Chicago - L.A., TOFC/COFC-heavy corridor succeeds in producing a better product and their competition - chiefly truck lines - continues to feel the pinch of labor shortages and high fuel costs, I predict the overall lessening of freight rates, if any, will be far less than the historic norms.
Michael:
Interesting comments regarding BH's cash positions and seemingly being at the wrong end of the cycle. However...if BH was heavily invested at the time of the dotcom boom, then it certainly worked out well, didnt it?
Lets see, Buffett was tsk-tsked for being out of touch and avoiding technology stocks...see Barron's cover story (December 27, 1999). Yet over the next three years BH shares appreciated 40% while the NASDaQ lost more than 60%. So, if he was fully loaded, it was in companies which allowed BH stock to perform quite well.
Perhaps you should read BH's annual reports, they are well worth the time invested...well thought out and well written. Unlike most annual reports, these contain considerably more than glossy pictures. Buffett and Munger discuss at length their investments and mistakes made.
All annual reports are available on line. Usually the reports take about an hour to read.
Convicted One wrote: Murphy Siding wrote: What would you think is driving this? Warren Buffett quote: - "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." Wasn't Berkshire one of the companies that bought part of EMD?
That was Berkshire Partners of Boston, not Berkshire Hathaway of Omaha (Buffett). Two completely different companies.
LC
MP173 wrote: Interesting comments regarding BH's cash positions and seemingly being at the wrong end of the cycle. However...if BH was heavily invested at the time of the dotcom boom, then it certainly worked out well, didnt it?
Well, what I was trying to point out was that he had about $3 billion in cash during that time -- he was heavily invested which meant he obviously thought it was at the beginning of a business cycle. Compared to $40 billion now.
Well aware of his feelings about tech stocks; but he had a tiny cash position during that period of time -- and of course both tech and nontech had quite a run during that period. However, if I tried to identify the time period as the non-dotcom boom, I'm not sure anyone would have understood the time frame I was referring to.
Bob-Fryml wrote:...but with the opening of the last segments of Chicago - Los Angeles double track corridor, BNSF will begin to enjoy a noticable increase in velocity, with a concomitant increase in locomotive and freight car utilization, and a measurable drop in delayed train expenses due to congestion.....Yes with a business cycle downturn there probably will be some downward pressure on freight rates, but if the BNSF Chicago - L.A., TOFC/COFC-heavy corridor succeeds in producing a better product and their competition - chiefly truck lines - continues to feel the pinch of labor shortages and high fuel costs, I predict the overall lessening of freight rates, if any, will be far less than the historic norms.
....Yes with a business cycle downturn there probably will be some downward pressure on freight rates, but if the BNSF Chicago - L.A., TOFC/COFC-heavy corridor succeeds in producing a better product and their competition - chiefly truck lines - continues to feel the pinch of labor shortages and high fuel costs, I predict the overall lessening of freight rates, if any, will be far less than the historic norms.
And I agree. The point of my earlier post was to the effect that something will happen in the next downturn that hasn't happened before as the rail industry as a whole "decongests" and that will be a reduction in marginal costs, which is what you are saying above. The difference between that reduction occuring as the result of a downturn is that there is no additional investment necessary to make it happen; whereas if and when it happens as a result of new constuction, that adds a cost element.
Bob-F,
Thank you for analysis that is other than scholastic. It sounds like you may be employable by a railroad.
Here is a bit of six degrees of separation trivia.
With the BH purchase, Marsico Capital Management becomes the second largest holder of BNI with 30+ million shares
Marsico was started by Tom Marsico in 1997.
Tom Marsico was previously the Investment Manager for the Janus Fund.
Janus Capital was previously own by Kansas City Southern Industries.
Just a couple of rail fans with money.
"We have met the enemy and he is us." Pogo Possum "We have met the anemone... and he is Russ." Bucky Katt "Prediction is very difficult, especially if it's about the future." Niels Bohr, Nobel laureate in physics
Hey, isn't this the guy who gave a sizable charitable donation amounting to billions...........to Bill Friggin' Gates?!
Maybe this buying of BNI on the high side is a sign of senility.
futuremodal wrote: Hey, isn't this the guy who gave a sizable charitable donation amounting to billions...........to Bill Friggin' Gates?!Maybe this buying of BNI on the high side is a sign of senility.
I believe that it was to the charitable foundation established by Gates, more than a slight shade of difference there. As mentioned earlier, Buffett has customarily been a long-term investor, and he sees things in that light.
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