Fri, 20 Apr 2012
By investing in high-quality, but capital-intensive, businesses, Buffett might be trying to prevent his successor from making a big mistake, says Sanibel Captiva's Pat Dorsey.
Jason Stipp: I'm Jason Stipp for Morningstar. A perennial topic ahead of the annual Berkshire Hathaway shareholders meeting is what might be on Warren Buffett's acquisition list. But perhaps an even more interesting discussion is to talk about what he's been buying recently, what he's bought historically, good and bad and see what we can glean from that. Joining me for that discussion is Pat Dorsey. He is the president of Sanibel Captiva Investment Advisers.
Pat, thanks for joining me.
Pat Dorsey: Hello.
Stipp: So in Warren Buffett's annual letter to shareholders, he had a little bit about his acquisitions, when he buys a whole business, and he said that he's not likely to divest these businesses because of the way they are acquired. He keeps them whole. One of the things that he sells, basically to people he wants to acquire, is the fact you're going to be in Berkshire, you're going to be a part of this family, and you're going to maintain control of your business. It's important that he not get rid of businesses left and right.
Dorsey: Exactly. It's sort of a personal ethical, look-you-in-the-eye kind of thing where, if you sell me this business, you have my word: I will not gut it two years from now.
Stipp: So what this means essentially though is, if he makes a poor decision and buys a business that he maybe doesn't love, he might be holding on to it for a while.
Dorsey: This does happen.
Stipp: So given the history of his acquisitions, and if you had to put a top list of the ones that he wished he could take back, what kind of businesses are those? What's on that list?
Dorsey: Well, the one that he's talked about publicly recently is a business called Dexter Shoe, which he bought in 1993, paying for it about $430 million, which doesn't sound like a lot. But the big issue is he paid for it in Berkshire stock. Something he rarely, rarely does, and he made a comment a few years ago that that purchase wound up costing Berkshire about $3.5 billion because of course Berkshire stock went up a lot since 1993 and the shoe business has been a little rougher, I would say. Obviously a lot of low-cost competition showed up; most shoe manufacturing, if not all is done outside the United States now. So that was not one of Mr. Buffett's brighter moments.
Stipp: Another thing that we know about Buffett, is he doesn't often invest in technology, but that doesn't mean that technological disruptions don't affect the businesses in which he's invested.
Dorsey: Yes. One he's talked about frequently of course is World Book, which is owned by Scott Fetzer Company, if you look in the Berkshire annual report. And of course, not a lot of folks have encyclopedias lining their bookshelves these days. There's this thing called the Internet, and frequently you look up information there. So World Book--the encyclopedia industry in general, I mean [just look at] Encyclopedia Britannica, as well--has just been demolished by the Internet. That's technological disruption, which has also affected his newspaper holdings. Buffett owns a number of newspapers, and that industry has really gotten hurt badly during the past couple of decades by the Internet, partially by the ease of access to information online, but also because the advent of things like craigslist has made it less valuable to be your only source for local classifieds.
Stipp: So Buffett, obviously, is known for his capital-allocation skills. His good decisions way outweigh those few poor decisions. But the concern that Berkshire shareholders have is that when someday he's not making those decisions, someone else will be, and what are the odds that those bad decisions, the ratio, could go up a little bit?
Dorsey: I think it's very interesting because, in my opinion, he's made some moves to put Berkshire on what I would call kind of a glide path, where it's going to be harder for his successor to make really bad decisions because Berkshire throws off lots of cash every year. So that cash needs to get reinvested in something. And the risk is that those somethings will not turn out well, or will turn out less well, in the successor's hands than in Buffett's hands.
But by buying very capital-intensive businesses like MidAmerican Energy, and especially like Burlington Northern, what Buffett has created is a claim on that cash. Now he has these businesses that every year say "I need some of that cash," a big chunk of it to build rolling stock, to buy new locomotives, or wherever it might be. What that does then is basically reduces the amount of extra cash that his successor has the opportunity to do either good or bad things with. It's kind of like trading some upside in exchange for protecting the downside.
Stipp: It reduces a little bit of that rope that someone might accidentally use to hang themselves.
Dorsey: Exactly. He has not given his successor as much rope as he has, certainly.
Stipp: It's very interesting because Buffett also in that same letter said he likes to look for businesses that don't require lot of capital. But obviously Burlington Northern and some of the others we've seen have been much more capital-intensive, and that's an interesting way to look at that. At the same time, though, if it is a capital-intensive business, you do want to make sure you're going to get at least a decent return from that business. How is he making sure that the businesses he buys, it's going to eat a bunch of money and give a really piddly return?
Dorsey: Well, of course, he is looking for an economic moat. Thank you for that softball right down in the middle there, Mr. Stipp, and of course Burlington Northern would enjoy a fairly strong competitive advantage. Once you have a railroad in between A and B, you would need a heck a lot of traffic to justify having a second one in between A and B. Burlington Northern tends to have enormous amounts of pricing power especially given the efficiency that the railroad industry has gained over the past couple of years, a couple of decades rather, as it's rationalize itself. So, Burlington Northern as an example is never going to knock the ball out of the park nor going to have a 30% return on capital, but it's very unlikely to go the way of a General Motors or a U.S. Airways, to name another Buffett mistake. It's a business which is likely to have good, but not awesome, returns in a very confident fashion.
Stipp: I will try to throw you one curveball from my last question then, Pat. If more of Berkshire's money, more of its return is in some of these more moderately returning businesses, does that seems it's chance for outperformance in the future even if these new folks who take over are great capital allocators is diminished?
Dorsey: Absolutely. I mean Buffett himself has said this that I mean he did the odds that Berkshire will vastly exceed the S&P 500 over the next 20 years is far lower than the odds that it would have exceeded at 20 years ago. Partially that's just the sheer size of the business, and partially that's because the composition of Berkshire has changed. It's no longer a collection of undervalued minority stakes in companies. It's now a lot of it: things like Iscar, things like Marmon, and things like Burlington Northern. These are very high-quality businesses. You're still getting the advantage of incredibly cheap financing from the very low-cost float that Berkshire operates. So I think the odds that over a decade-long time span, Berkshire outperforms the S&P by a modest amount. I do think there is a very good chance of that. But [Berkshire] blowing the doors off the S&P? Almost impossible.
Stipp: In your opinion, do you think that those prospects are priced into the stock at this point?
Dorsey: Absolutely not. That's the thing is that right now you're getting the stock here at an incredibly reasonable valuation; there are many different ways you can value Berkshire, obviously. But if you basically back out the value of the publicly traded securities right now and assume that the insurance businesses are worth nothing, in that they exist just to generate float--which is a pretty conservative given they generally made money, as well--the operating business is trading between 5 and 6 times earnings. For Iscar, Marmon, See's Candies, and Burlington Northern, I'll pay 5 or 6 times earnings and might even argue they are worth more.
Stipp: All right, Pat some great insights on Berkshire, its acquisition history, and future and also the stock today. Thanks for joining me.
Dorsey: Thanks so much.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.