Wisdom from Warren on Playing the Long Game
Warren Buffet’s annual letter to shareholders is an excellent resource for entrepreneurs, managers, and investors. The writing is concise, clear, and packed with wisdom. In his most recent letter, Buffet provides an update on Berkshire Hathaway’s investment in rail transportation provider Burlington Northern Santa Fe (BNSF) that is particularly insightful and highlights the benefit of taking a long term approach to investing.
BNSF is the largest freight railroad in the US and is wholly owned by Berkshire since 2010 when Buffett acquired 100% of BNSF’s outstanding equity. At the time of the acquisition, the deal was one of Berkshire’s largest ever investments but was not emblematic of the type of investment that Buffett and Munger preferred in Berkshire’s early days.
Historical Preference for Businesses with Low Capital Intensity
Railroads are highly capital intensive. Buffet estimates that since Berkshire’s acquisition of BNSF in 2010, the cost of maintaining BNSF’s rail network and equipment during the ensuing 14 years has exceeded GAAP depreciation by $22 billion. In other words, to sustain BNSF’s current level of business the company must allocate a meaningful portion of annual earnings to maintain tracks, locomotives, bridges, etc. This limits the cash that can be returned to investors.
In Berkshire’s early days, owning a company like BNSF would have been an obstacle to compound earnings growth relative to the prospects of alternative investments in less capital intensive businesses. Buffet in his 2009 letter to shareholders states that in Berkshire’s formative years “...Charlie and I shunned capital-intensive businesses such as public utilities. Indeed, the best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow. We are fortunate to own a number of such businesses, and we would love to buy more.”
Justifying the Departure From Capital Efficiency
What compelled Berkshire to acquire BNSF despite the capital intensity of railroads? One, Berkshire faced a high class problem circa 2009 when it had over $30 billion of cash to invest. It turns out the universe of investment opportunities becomes narrow when attempting to deploy tens of billions of dollars. And two, Buffett projected that railroads, like utilities, would deliver significantly increased earnings over time due to the essential nature of rail services to the economy and the high barriers to entry for competitors. On the latter, take for instance the $70 billion balance sheet value of BNSF’s tracks, trains, bridges, and other fixed assets. Buffett estimates that replicating these assets would take decades and cost more than $500 billion. Care to enter a market that requires $500 billion of startup capital?
In addition to entry barriers, rail has numerous sustainable advantages relative to trucking, especially for long haul freight. Rail labor productivity is higher than truck labor productivity. Fuel efficiency per ton mile is four times better for rail versus truck, and rail is over four times cheaper than trucking per ton mile. Of course, this isn’t to imply that trucking lacks value in the transportation ecosystem. Trucking serves much needed short-hauls to distribution centers and retail facilities, and for time-sensitive freight trucking offers valuable flexibility and speed. But for long-haul, non-time-sensitive freight, perhaps no transportation mode can compete with rail’s efficiency. Our interpretation of Buffett’s comments is that he’s betting rail’s advantage is not likely to erode in the foreseeable future.
The Cost of Preserving an Attractive Stream of Cash Flow
In our most recent post on business valuation, we wrote that a company is worth its stream of future cash flows, discounted for the risk associated with producing the cash flows. Rail is a great example of a business that has a high degree of cash flow certainty due to the previously mentioned competitive advantages and the long-term prospects of rail to remain a pivotal mode of freight transportation. Utilization of rail assets will vary due to seasonality and economic cycles, yielding fluctuations in the level of earnings and periods of depressed earnings, but these periods will be offset by the consistent, albeit expensive to produce, long term earnings generated by rail.
The high level of capital investment in rail infrastructure is the price Buffett pays to protect the hard-to-replicate stream of cash flows produced by rail. In this case, the probability of cash flow is inversely correlated with the magnitude of cash flow. Buffett is effectively paying a premium (reducing magnitude of cash flow) to preserve a high probability of future earnings. The trade-off in this equation is growth. Cash flow will be lumpy from year-to-year, as it has been since 2010 when Berkshire acquired BNSF, but the consistency of positive cash flow will trigger reinvestment opportunities that generate one of Buffett and Munger’s most formidable tailwinds – compounding.
Sticking With BNSF, Despite Performance Slowdown
According to Buffett’s most recent annual shareholder letter, BNSF’s earnings declined in 2023 at a rate greater than Buffett expected. Relative to competing railroads, such as Norfolk Southern and Union Pacific, BNSF’s profit margins have also compressed since Buffett’s acquisition of BNSF in 2010. This performance decline may warrant that an investor begin looking for the exit, but not Buffett and not with BNSF. Buffet goes on in his letter to state that “A century from now, BNSF will continue to be a major asset of the country and of Berkshire. You can count on that.”
Buffett’s premonition that BNSF will flourish for the next 100 years is bold, but grounded in sound logic. Reproducing BNSF’s track footprint is not feasible from a time and cost standpoint, which limits competitive threats from rail operators. BNSF’s rail lines, which exist predominantly west of the Mississippi River, cover a vast expanse and are vital economic arteries that facilitate the transportation of billions of dollars of freight to major American cities and suburban communities. The odds are high that you encounter a product that moved on a BNSF train on a daily basis, from food, to apparel, to building materials and beyond.
Picking a Partner With a Long Term Horizon
Although the takeaways from Buffett’s 2023 shareholder letter point to a number of investing lessons, there are equally important reads for business owners contemplating partnership with equity investors, whether for a full or partial business sale. Primarily, finding an investor or acquirer who takes a long term view of a business allows for patience in the face of depressed performance. Decisions that benefit the long term compound growth of the company rather than decisions that optimize for near term performance will create an optimal backdrop for a business. Although Buffett acquired 100% of BNSF, it’s common for sellers to roll a portion of equity in a business sale and in doing so to invest in the continued success of the business. In this case, it’s in the seller’s best interest to seek compounding growth that offers attractive returns on the rolled equity.
For those sellers who transition out of the business, finding replacement managers is critical, as is positioning employees for continued personal and professional growth. Betting on good managers and granting them independence is one of Buffett’s key investment tenants. So too is finding businesses with a “profit picture that for decades to come seems reasonably predictable.” This predictability is key to unlocking compound growth and letting time become an ally of returns rather than pursuing growth through big, near-term bets, or excessive leverage.
Conclusion
Despite BNSF’s capital intensity, the business offers a critical service with a hard-to-replicate network of tracks and equipment. Although the company has faced margin compression relative to peers and income declines in 2023, Buffett’s long term perspective offers management the flexibility to plan for the next decade instead of the next quarter, and to avoid the pitfalls of short-term decision making that can be detrimental to long term performance. In doing so, the wisdom of compounding can work its magic, perhaps for the next 100 years.
