Warren Buffett’s Railroad Stock

Back in April of this year, America’s most-respected investor, Warren Buffett, disclosed that he (via Berkshire Hathaway) had become the #1 shareholder of Burlington Northern Santa Fe (BNI). This railroad encompasses some 49,000 miles of track in 28 states and two Canadian provinces, 85,000 freight cars, 6,000 locomotives and 3,000 containers … plus miscellaneous ports and auto distribution facilities.

He also acquired substantial amounts of two other railroads in the same period.

When the news broke, investors eager to follow the master jumped on BNI, sending the stock climbing from 83 to an all-time high of 95 in ten trading days. Four months later, BNI, pulled down by a market correction, was selling at 74. And now, having rebounded with the broad market, it’s back up to 84, just 2% higher than where it started this six-month voyage.

Of course, six months is far too short a period in which to judge a value-oriented investment. More important, Warren Buffett, as far as we know, never paid more than 82 for his shares. Those folks who deluded themselves into thinking they were following the master when they were buying above 90 were only getting half the equation right. They forgot the importance of price.

But now that the stock is back at 84, you might once again think about joining Mr. Buffett.

His rationale for owning BNI (and other railroads) seems to center around the observation that transportation is a steady business with major barriers to entry, and that these stocks will enjoy long-term growth.

But I fail to see any great value here.

Looking at the chart, I see that BNI climbed from 23 in late 2003 to a high of 88 in early 2006, dramatically outperforming the broad market at the same time.

This advance, to some extent, reflected the company’s growth over the same period; from 2004 through 2006, annual revenue growth at Burlington Northern averaged 17%!

But in the last year? The growth is back in the low single-digits. And the stock has underperformed the market over the past nineteen months.

Furthermore, I see that analysts have recently lowered their earnings estimates for BNI going forward. For 2007, they expect earnings growth of just 2%. For 2008, they expect growth of 15%.

But the company’s PE ratio is now 16. And its PSR (price to sales ratio) is 2. I just don’t see value there. More importantly, a check of Cabot Benjamin Graham Value Letter, which is based on the system developed by the fellow who taught Warren Buffet how to invest, doesn’t include BNI on either of its buy lists.

And there’s one more factor.

If you buy BNI now, when are you going to sell? Do you think you’ll learn about Warren’s decision to sell before he’s done selling his shares … or after?

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Sticking with the topic of transportation …

My parents recently returned from a cruise on the Illinois River aboard the sternwheel riverboat “Spirit of Peoria.” Though it looks like a classic old boat, with its 22-foot diameter wheel, and wedding cake superstructure, the boat was actually built in 1988. The hull is steel. The wheel is fiberglass and wood. And the power comes from two Caterpillar 3412 diesels that turn two 350 kW generator sets that turn two 12-inch-wide belt chains.

My folks had a great time, and my father was actually more impressed by the other marine traffic, in particular the big barges that carried corn and other agricultural products up and down the river.

And that, I hope, is reason enough to segue into a little story on the Merchant Marine Act of 1920, commonly known as the Jones Act for its sponsor, Senator Wesley Jones.

Jones, by the way, was a Republican senator from Washington from1909 to 1932, when he failed to win re-election.

The Jones Act, which became a law right after World War I, governs cabotage, which is the transport of goods or passengers between two points in the same country. Originally pertaining to sailing vessels, the word cabotage is derived from the French caboter, meaning to sail along a coast, which is close to the Spanish cabo (think Mexican beaches) and stems from the Latin caput, for head.

Anyway, the point of cabotage regulations is to achieve control of a country’s internal shipping so that foreign powers are excluded. The benefits include national security (the main goal in 1920), industry and job security, and public safety.

Nowadays, cabotage applies to transport accomplished via any mode, including rail and air. Cabotage regulations, for example, are the reason that foreign airlines can’t sell Americans tickets to fly between two American cities, despite the fact that they fly there. In many cases, the practice of code sharing gets around this restriction.

But back on the high seas, the Jones Act still exerts enormous power. It restricts the carriage of goods or passengers between U.S. ports to U.S. built and flagged vessels. This applies to barge operators on the inland waterways, freighters on the Great Lakes, and deep-sea ocean carriers serving Hawaii, Alaska, Puerto Rico, and Guam.

It stipulates that at least 75% of the crewmembers of these ships be U.S. citizens. And it mandates that foreign repair work of these ships’ hull and superstructure be limited to 10% foreign steel by weight … which effectively prevents them from being refurbished at overseas shipyards. The Jones Act also guarantees rights to seamen, ensuring, among other things, that seamen injured during a voyage are fully compensated.

Now any student of free markets will recognize that those restrictions raise costs, reduce competition and, in the long run, reduce customer satisfaction.

In the past decade an increasing number of politicians have come to the same conclusion!

Representative Nick Smith (R-Mich) tried to get the Jones Act repealed in 1996, 1997 and 2001 arguing that it would lower costs for a multitude of U.S. industries and consumers. In 1998, Senator Sam Brownback (R-Kan.) introduced a bill to repeal the U.S. built requirement of the act.

And in 2003, Representative Ed Case (D-Hawaii), attempted to repeal the act, arguing that it increased the cost of living in the islands and claiming that savings of 40% would be gained in some sectors by repeal.

Most recently, Midwest grain producers have lobbied for repeal, arguing that a shortage of qualified vessels on the Mississippi River has forced poultry producers in the Southeast to import foreign grain on foreign ships. They argue that increased competition would not only lower the cost of shipping but also put pressure on railroads to reduce their costs! (Which suggests that Warren Buffet, railroadman, will benefit more if the Act stays in place.)

But every effort to repeal the Jones Act has failed, and what’s interesting about this is that in this increasingly polarized political climate, the lines that separate the critics and defenders of the Jones Act cross through both political parties!

There are Republicans and Democrats who want it repealed to lower barriers to trade and thus costs for their constituents. But there are Democrats who defend it for the job protections it provides to seamen and shipbuilders, and there are Republicans who defend it for its contribution to national security.

I’m no expert on the issue – I’ve only just scratched the surface – but it’s clear to me that the world has changed a lot since the Jones Act became law. If it were proposed today, no doubt its language would be substantially different … and maybe it wouldn’t pass.

But political forces become entrenched. Our representatives in Washington act first to protect their own jobs, second to serve their own constituents and third to serve their country.

And so the Jones Act lives on.

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Which brings me the final act of this transportation trilogy.

Back on March 5, I wrote about finding great investment ideas by scanning the lists of stocks hitting new highs. Going through that exercise then, I zeroed in on the shipping industry, in particular the class of shippers known as dry-bulk, which carry coal, iron ore, phosphate, grains, and more.

And I discussed three stocks in particular. The first was Diana Shipping (DSX), which had earned it a spot in Cabot Top Ten on February 26.

In that issue, editor Mike Cintolo wrote, “Shipping stocks are showing renewed signs of life, and Diana is the first to earn a spot in the Top Ten in some time. The company is actually headquartered in Greece, and the stock is strong today because the trends in both the shipping industry as a whole, and for Diana in particular, are set to improve markedly. This industry is as cyclical as it gets, but today a strong world economy and a limited supply of vessels mean shipping rates are on the upswing. Combine that with Diana’s expansion (it operated an average of 14.4 vessels in the fourth quarter, up 33% from a year ago) and the stars are aligned for big earnings growth in 2007.”

My second stock on March 5 was “the aptly named DryShips (DRYS), which owns and operates a fleet of 34 drybulk carriers comprising 5 Capesize, 24 Panamax, 3 Handymax and 2 new-building Panamax vessels, with a combined deadweight tonnage of approximately 2.8 million. In the fourth quarter, DryShips operated an average of 33.86 vessels at an average daily charter rate of $24,466, compared with an average of 27 vessels at a daily rate of $23,981 last year.”

And my third stock on March 5 was “Navios Marine (NM), which has been very busy lately. Earlier this month, it purchased Belgian shipper Kleimar N.V. for $165 million. And then on Thursday, February 22 it began trading on the New York Stock Exchange, after 15 years on the Nasdaq. Navios controls 45 vessels (21 owned and 24 chartered-in), making it the largest U.S.-listed dry-bulk carrier, and the company has big ambitions, particularly because of the potential for growth in China.”

My final advice back then was this: “In the end, I can’t say any of these stocks are particularly attractive long-term, but that’s mainly because of the cyclicality of the industry. … On the other hand, if the current upcycle runs longer, any one of the three bulk carriers might do fine. I have a bias against Navios, because its stock hasn’t crossed the $10 threshold yet. And Diana and DryShips both need to work right here to get above their March 2005 peaks of 18 and 24, respectively. But if they can, they could easily run further from here.”

Well, from that point to today, Navios, the low-priced stock, is up 106%. Diana is up 122%. And DryShips is up a whopping 512%.

From which you should conclude that the stocks themselves, which were hitting new highs, were the best guides to their future course! Or, as my father taught me, a trend, once in effect, tends to persist longer and carry further than originally expected.

So what’s next? Well, these charts are still strong. And the industry fundamentals are bright.

Fundamentally, the cost of renting a ship to carry raw materials from Brazil to China has nearly tripled to $180,000 a day from $65,000 a year ago.

The Baltic Dry Exchange index (which tracks ship rental rates) hit a record Friday after rising 169% in the past year.

And shippers are expecting even higher rates in 2008 and perhaps even into 2009, when enough new ships are finally expected to hit the waters to ease the shortage.

These trends aren’t affecting shippers of oil and finished goods; there are enough oil tankers and containers to go around. But the shortage of dry-bulk carriers persists, and the trend of these three leading stocks remains up.

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