Buffett Overpaid, and It Made Sense

"Buffett overpaid for Burlington Northern Santa Fe Corp. and ... should have instead returned the company's excess cash to investors."

That quote, pulled from a news article, is a common attitude when it comes to Berkshire Hathaway's (NYSE: BRK-A)(NYSE: BRK-B) November purchase of railroad giant Burlington Northern.

The $100-per-share buyout represented a 30% premium on Burlington's stock price -- a stock that had already gained 50% over the previous eight months. By any valuation metric, Buffett was coughing up top dollar for Burlington. Coming from the guy who coined the phrase, "price is what you pay, value is what you get," and who built his reputation buying companies like Coca-Cola (NYSE: KO  ) and American Express (NYSE: AXP  ) at fire-sale prices, this was a puzzle. Berkshire suddenly looked more like Blackstone (NYSE: BX  ) .

Buffett also partially financed the deal with Berkshire's common stock, a rare move for him, and one he often later regretted. And since he was willing to use Berkshire's stock as currency, he was sending a clear signal to the market: Either Berkshire shares were fully valued (if not overvalued), or he was using an undervalued stock to buy Burlington, making the deal even more expensive than it looked.

Please don't tell me he's lost his marbles
On Saturday, Berkshire released its 2009 letter to shareholders. Within, Buffett went into detail on the mechanics and valuation of the Burlington acquisition. In short, yes, Berkshire paid a full price. Yes, Berkshire shares were probably undervalued at the time. And yes, that means the full price could turn into a dear price.

But the decision nonetheless made sense. Here's exactly what Buffett had to say:

In our [Burlington] acquisition, the selling shareholders quite properly evaluated our offer at $100 per share. The cost to us, however, was somewhat higher since 40% of the $100 was delivered in our shares, which Charlie and I believed to be worth more than their market value ...

In the end, Charlie [Munger] and I decided that the disadvantage of paying 30% of the price through stock was offset by the opportunity the acquisition gave us to deploy $22 billion of cash in a business we understood and liked for the long term. It has the additional virtue of being run by Matt Rose, whom we trust and admire. We also like the prospect of investing additional billions over the years at reasonable rates of return. But the final decision was a close one. If we had needed to use more stock to make the acquisition, it would in fact have made no sense. We would have then been giving up more than we were getting.

The price of being huge
One of the unfortunate rules of finance is that returns wither with size. As individual investors, we can meaningfully buy any stock in the market universe, since the few thousand bucks we'll invest probably won't contort the company's stock price. Our tiny investments mean nothing to the market, but they can mean big bucks for our humble portfolios. The world is our oyster.

Not so for big investors like Berkshire. Heck, Berkshire makes more than $1,000 a minute in dividends on its stakes in General Electric (NYSE: GE  ) and Goldman Sachs (NYSE: GS  ) -- and that's a fairly small portion of the overall portfolio. When cash piles up that fast, you have to be able to deploy it in massive chunks -- billions at a time -- to make a dent in the portfolio. That purges most small investment opportunities, forcing investors like Berkshire to settle for lower returns.

That's exactly what happened with Burlington. Paying an overvalued price made sense because it provided the opportunity to deploy tens of billions of cash at reasonable, but not great, returns.

For decades, Buffett has repeated a similar line in Berkshire's annual letters: "[O]ur performance advantage has shrunk dramatically as our size has grown, an unpleasant trend that is certain to continue ... huge sums forge their own anchor and our future advantage, if any, will be a small fraction of our historical edge."

After the Burlington deal, it's clear he isn't kidding.

Fool contributor Morgan Housel owns shares of Berkshire Hathaway. Berkshire Hathaway, Coca-Cola, and American Express are Motley Fool Inside Value selections. Berkshire Hathaway is a Motley Fool Stock Advisor recommendation. Coca-Cola is a Motley Fool Income Investor selection. The Fool owns shares of Berkshire Hathaway, and has a disclosure policy.


Read/Post Comments (28) | Recommend This Article (61)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 01, 2010, at 4:11 PM, jthpph wrote:

    A good bit of the west to east freight on BNS results

    because todays container ships cannot negotiate the

    Panama Canal. With the expansion expected to be

    completed in three years 95% of cargo going to the

    east coast from asia can pass through the canal. Freight rates are expected to drop by 30 percent, or so.

    With BNS volumn limited by revenue

    might see a dip in the near term.

  • Report this Comment On March 01, 2010, at 5:27 PM, royblan wrote:

    jthpph is right that east coast traffic running via Panama could cut into BNSF (not BNS, if you please) intermodal results, But IM was just 28.4% of BNSF total revenue, $14B for the year. Coal was 25.9% meaning that 46% of sales were for everything from autos to grains to building products and chemicals. Moreover, BNSF is investing $1 billion to double-track the entire LA-Chi route adding capacity that will mean another $1.4 billion A YEAR forever in sales. Finally, BNSF has some of the best commercial and financial people in the biz and they will quickly replace what falls out the bottom.

  • Report this Comment On March 01, 2010, at 6:01 PM, mackvee wrote:

    plus they own just a tad of real estate along the way.

  • Report this Comment On March 01, 2010, at 6:10 PM, PortlandFoolio wrote:

    I'm not too terribly knowledgeable on railroads, but I am thinking that this could have been a (typically) savvy investment given the fact that railroads seem like a natural (green, even?) growth opportunity for transportation in the US. As everyone knows, China is kicking our collective arse in green technologies and so many other areas, one of which is high-speed rail. And, Obama was recently quoted as wanting more innovation in this area, certainly with China in his rear view mirror ("some objects may be closer than they appear"). Might WB and CM have figured this into their calculus?

  • Report this Comment On March 01, 2010, at 6:22 PM, langco1 wrote:

    buffett overpaid and at a real bad time.this has already led to several downgrades of his company

  • Report this Comment On March 01, 2010, at 11:13 PM, dstb wrote:

    I don't buy his logic. He overpaid plain and simple. I used to own Berkshire and if I was still a shareholder I would have preferred a nice, large one-time dividend rather than paying that price for a railroad. If Congress ever decides to go with capping the railroads' rate increases BNSF will get hammered. You will start to hear that talk again when oil gets back up over $100. There are risks to the railroads and they are very capital intensive.

    I also don't buy into the myth that Buffett HAS to buy huge companies. He needs to hire a larger staff to help him search for good opportunities. It is likely that there are numerous mid-sized companies that offer better price-growth potential than a BNSF, but he and Charlie can't do it all.

    The fact is that despite Buffett's genius he appears to be conflicted at times in his investment philosophy. I think he bought this company because the railroad business and BNSF's managment give him a warm and fuzzy. At much cheaper prices it would be one thing but at $100 per share it's not good enough for me.

  • Report this Comment On March 01, 2010, at 11:14 PM, dstb wrote:

    I don't buy his logic. He overpaid plain and simple. I used to own Berkshire and if I was still a shareholder I would have preferred a nice, large one-time dividend rather than paying that price for a railroad. If Congress ever decides to go with capping the railroads' rate increases BNSF will get hammered. You will start to hear that talk again when oil gets back up over $100. There are risks to the railroads and they are very capital intensive.

    I also don't buy into the myth that Buffett HAS to buy huge companies. He needs to hire a larger staff to help him search for good opportunities. It is likely that there are numerous mid-sized companies that offer better price-growth potential than a BNSF, but he and Charlie can't do it all.

    The fact is that despite Buffett's genius he appears to be conflicted at times in his investment philosophy. I think he bought this company because the railroad business and BNSF's managment give him a warm and fuzzy. At much cheaper prices it would be one thing but at $100 per share it's not good enough for me.

  • Report this Comment On March 01, 2010, at 11:41 PM, memoandstitch wrote:

    An old Chinese wisdom: No business lasts more than three generations.

  • Report this Comment On March 01, 2010, at 11:42 PM, memoandstitch wrote:

    An old Chinese wisdom: No business lasts more than three generations.

  • Report this Comment On March 02, 2010, at 1:07 AM, grungeboater wrote:

    What most people love to overlook is the possibility that popular and dogmatic thinking is clouding their minds. True, that WB has a superior track record when it comes to 4+ decades of investing. Not everything he touches turns to gold, however.

    I havent paid much attention to WBs moves in the past 10 years for the same reason I didnt follow the popular and dogmatic opinion several years ago regarding Citi Bank being a good company to invest into. SOME THINGS ARE JUST TOO BIG TO BE PROPERLY MANAGED AND SUCCEED.

    My other concern regarding this issue is rather obvious although I never see printed or hear spoken. When it comes to Warren Buffet no one dares to assert that even the sharpest minds at some point lose their edge.

  • Report this Comment On March 02, 2010, at 4:08 AM, Usnzth wrote:

    Lately, I have read often that Buffett cannot pick up good deals like he used to because he has too much money.

    I wouldn't mind having his problem.

  • Report this Comment On March 02, 2010, at 4:09 AM, Usnzth wrote:

    An old Chinese wisdom: Wait more than one minute before hitting the "Post Your Comment" button again.

  • Report this Comment On March 02, 2010, at 5:31 AM, TopAustrianFool wrote:

    "Paying an overvalued price made sense..."

    Then it is not overvalued. The price is the price and obviously he seems its justified. The price an investor pays for a given asset may be different depending on his own valuation. I am no fan of Buffett, but it is a ridiculous statement when some one thinks anyone else paid too much.

  • Report this Comment On March 02, 2010, at 7:10 AM, privacyinvesting wrote:

    "buffett overpaid and at a real bad time.this has already led to several downgrades of his company"

    It's so great! Now, it's a best time to buy in!

    http://www.gokandy.com/Blog/Blog.aspx?Id=149

  • Report this Comment On March 02, 2010, at 7:10 AM, privacyinvesting wrote:

    "buffett overpaid and at a real bad time.this has already led to several downgrades of his company"

    It's so great! Now, it's a best time to buy in!

    http://www.gokandy.com/Blog/Blog.aspx?Id=149

  • Report this Comment On March 02, 2010, at 10:02 AM, MORK000 wrote:

    RIGHT ON BERKSHIRE LET THE OTHER FOOL'S WORRY. YOU GOT IT RIGHT.

  • Report this Comment On March 02, 2010, at 10:32 AM, Superdrol wrote:

    You can buy the S&P 500 index now and get that tossed in there plus dividends.

  • Report this Comment On March 02, 2010, at 10:43 AM, Gorm wrote:

    If fossil fuel prices surge in coming years I can see the economies of railroads moving products East and West while long haul trucking is reduced to North and South arteries feeding off rail depots.

  • Report this Comment On March 02, 2010, at 10:48 AM, Gorm wrote:

    If fossil fuels prices were to surge, I could see the benefits of East, West rail moving products fed by North, South long haul truckers.

  • Report this Comment On March 04, 2010, at 12:17 AM, mikecart1 wrote:

    Buffet is overrated and probably the luckiest guy to ever walk the Earth with exception to Michael Jordan.

  • Report this Comment On March 04, 2010, at 7:25 AM, deepestvalue wrote:

    Buffet looks at Burl. No. as a utility not as a company with a great brand like Coca Cola.

    Once you see this massive buy as a utility, it makes perfect sense

  • Report this Comment On March 05, 2010, at 12:02 PM, Cetamura wrote:

    I've always said he's not an investor like you and me but an empire builder. A captain of industry, as they used to say. Berkshire is now a conglomerate of old and in fact not a well thought out one. He's been trying to increase synergies between the various companies but it looks like an afterthought. Buying a utility is the only way of deploying large amounts capital: you can't expect a real winner but you keep the principal plus hopefully a steady stream of dividend

  • Report this Comment On March 05, 2010, at 1:02 PM, Ellisee wrote:

    Buffett did not overpay.

    Burlington was worth a minimum of 100, probably lots more due to the "priceless" right of ways.

    That's why he bought 22% of the company at 70 and change.

    He paid a fair price, even concerning the undervalued stock issuance for a railroad which has a moat as long and wide as a railroad bed.

    BNSF shareholders who elected for stock still made out okay if they hold their BRK.

  • Report this Comment On March 05, 2010, at 11:23 PM, Buzbabiz wrote:

    That's a nice problem to have!

  • Report this Comment On March 06, 2010, at 3:20 AM, fatkid19 wrote:

    Will, Will, what do we have here more daddy war bucks saying I would not have paid that much, he paid too much. Let me give you fellows a little information that you can check out for your selves. For many years now the BNSF has produce a billion dollars a quarter in revenue. Hell with that kind of revenue exchange you can make profit just on the interest on the check book. There is something else, I hinted about it in previous posts, but most of you are still too stupid understand the vision that Buffet has. Let me spell it out for you. If the United States ever has a high speed rail system, Who do you think it will run on? I will tell you High speed rail will put South West and American Air lines out of business, that right you heard it here first.

    BNSF owns all the rails into the coal mines that the other railroads pay to move coal out of Wyoming.

    The communication system that rings three quarter of the United States can be morphed into an instant cell phone competitor over night due to its existing infrastructure not to mention that you are still going to pay BNSF to bring all of the commodities that we all have to have to market.

    you guys are pretty dense

  • Report this Comment On March 07, 2010, at 1:14 PM, wonteach wrote:

    This article is odd. It begins with a quote, regarding the alternative of distributing the excess cash to the shareholders, and proceeds to disagree with that quote while explaining all the reasons that the quote was correct! Never once does the writer address the possibility of distributing Berkshire's cash to its shareholders in the form of dividends, and the article's explanation for why Buffet HAD to pay through the nose for BN constitutes a strong argument for just such a distribution.

    Strange.

  • Report this Comment On March 08, 2010, at 5:38 PM, Suncitybaud wrote:

    Perhaps, Buffett had a second agenda that could be covertly executed in his purchase of Burlington Northern. Namely, to be able to split the "B" shares so as to increase demand by small investors for his own stock. Not many around who wish or are willing to spend $3000-4000 for one share; and very very few who would sink a $100,000 for one "A" share.

  • Report this Comment On March 09, 2010, at 3:41 PM, rfaramir wrote:

    Maybe Buffett had an eye towards the coming mega-inflation: "it provided the opportunity to deploy tens of billions of cash at reasonable, but not great, returns."

    When you've got billions in US dollars and the government is printing (electronically mostly) trillions, you get worried, and get out, if you feasibly can. He did.

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