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"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.