Buffett's Big Railroad Bet

11/9/2009


Uncertainty regarding the business outlook has triggered volatile trading, with transportation and other cyclical stocks under heavy selling pressure until railroad Burlington Northern ($97; BNI) surged on a takeover agreement with Berkshire Hathaway ($3,325; BRKb). As a hedge, we’re holding about 25% of our equity portfolios in Vanguard Short-Term Investment-Grade ($10.59; VFSTX), a relatively low-risk bond fund.

All-in wager

After reaching a 12-month high on Oct. 20 at 4,045.11, the Dow Transports slumped 11% over nine trading sessions before the Nov. 3 deal for Burlington spurred a single-day bounce of 5.3%. Warren Buffett, the legendary investor who runs Berkshire Hathaway, is considered an astute judge of value, and many saw his bid as a bullish indicator for the economy.

Buffett encouraged such an interpretation, calling the $26 billion deal an “all-in wager on the economic future of the United States.” Still, for at least four reasons, viewing the takeover as an all-clear signal for the Transports would be a mistake:

First, Buffett is known for having a very long investment horizon, saying his ideal holding period is forever. The takeover bid should not be viewed as a near-term call for a rebound in railroad freight volumes, which have begun to stabilize after one of the steepest declines in 50 years.

Second, it is hard to argue Buffett is getting a bargain. The deal price equates to more than 18 times Burlington’s expected 2010 earnings. Over the last 10 years, the stock has seldom traded at such a rich valuation. For the Transports, the average and median price/earnings ratios using next-year expected earnings are at the highest levels in at least five years.

Third, in a departure from Buffett’s typical deals, at least 40% of the purchase will be paid with Berkshire stock. Indeed, some skeptics saw the deal as a clever way of diversifying Berkshire’s heavy concentration in the insurance sector.

Fourth, the takeover had a limited impact on the broader market. The Dow Industrials and S&P 500 Index were roughly flat on the day of the announcement. Railroad stocks rallied broadly, but the Transports remain 8% below their Oct. 20 high.

Conclusion

The stock market’s course hinges on the majority money opinion, not the opinion of most investors. Buffett’s opinion counts for far more than that of the typical investor, but no single player can change the market’s primary trend. Until the Industrials and Transports suffer significant corrections and then rebound to new highs, the direction of the primary trend will remain in doubt.


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