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The Truth Behind Warren Buffett's Billion-Dollar Railroad Bet

Railroads break down. They cost billions to maintain. Questions about their future abound.

Source: Flickr / Greg Gjerdingen.

Yet in 2009 Warren Buffett decided to make an "all-in wager on the economic future of the United States," as Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) acquired railway Burlington Northern Santa Fe (BNSF) for $44 billion.

And in this major move we can see one critical truth that is often undiscussed when we consider where Warren puts his money.

The massive costs
Take a step back and consider in 2007 Buffett revealed his "dream business," See's Candy, required investments worth $32 million in total over the previous 35 years. But in "the meantime" its earnings came in at $1.4 billion. He went on to say:

It's far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.

BNSF touts last year it made "a record $4 billion" in capital investments and it expects to make another $5 billion this year.

You'd be hard-pressed to say $9 billion spent over two years would describe a business as having "virtually no major capital requirements."

So has Buffett contradicted himself? Has he lost his touch?

The answer, of course, to both of these questions, is no. As it turns out, Buffett's billion-dollar bet in BNSF has been a stroke of pure genius, and the quote in the picture above from his mentor Benjamin Graham helps explain why Berkshire Hathaway is poised to reap billions from its investment. 

The intelligent investment
Let's revisit the words of Buffett's mentor, which Buffett reminded us of this year:

Investment is most intelligent when it is most businesslike.

Buffett loves cheap stocks, but he has also said, the price is simply "what you pay."

There are always stocks which are deemed to be trading at discount. For example at the end of 2005, Radio Shack (NYSE: RSHCQ  ) was trading at a staggeringly low 9.4 price-to-earnings ratio whereas the S&P 500 ratio nearly doubled it, hovering at 18. A simple glance would say it's a worthwhile buy when considering only the relative price. 

Yet since then, even with the Great Recession, the S&P 500 has delivered a total return of nearly 90%, but the price of Radio Shack has plummeted nearly 95%, from $17.78 to $1.38. Radio Shack offered a compelling price, but the underlying business was bound to fail.

Price was surely a consideration when Berkshire Hathaway bought BNSF, what Buffett really clung to was the business prospects offered by the railway. In 2010, Buffett described why he and Charlie Munger were excited about the future of BNSF, noting:

Both of us are enthusiastic about BNSF's future because railroads have major cost and environmental advantages over trucking, their main competitor. Last year, BNSF moved each ton of freight it carried a record 500 miles on a single gallon of diesel fuel. That's three times more fuel-efficient than trucking is, which means our railroad owns an important advantage in operating costs. Concurrently, our country gains because of reduced greenhouse emissions and a much smaller need for imported oil. When traffic travels by rail, society benefits.

Buffett didn't make the investment simply because the price was attractive. In fact, there's no mention of it. Instead, he saw the business offered by BNSF both was, and is incredibly valuable. 

Since 2011, its revenue has grown by 13% to $22 billion. And its net earnings growth is even more impressive, rising by nearly 30% to $3.8 billion.

But it isn't just the bottom and topline results which are eye-opening. Buffett also noted in the 2010 letter; "A little math will tell you that more than 11% of all inter-city ton-miles of freight in the U.S. is transported by BNSF. Given the shift of population to the West, our share may well inch higher."

And this year, he revealed he was exactly correct about its market share being able to "inch higher," as it stood at nearly 15% of all inter-city freight.

The price was compelling, but clearly the business -- like that offered by See's Candy -- was even more captivating.

The key takeaways
Does this mean Buffett suggests we should blindly make an investment simply because a company has a great businesses? Of course not, for Buffett himself has said, "a business with terrific economics can be a bad investment if the price paid is excessive."

What we must see when we make an investment, it that we shouldn't think we're simply buying a stock, but instead a business. And we must try to determine the relative value of both.

In Buffett's own words:

In the end, what counts in investing is what you pay for a business – through the purchase of a small piece of it in the stock market – and what that business earns in the succeeding decade or two. 

Ultimately, we're buying businesses. Not stocks.

Warren Buffett just bought nearly 9 million shares of this company
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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 June 22, 2014, at 8:49 PM, anyon wrote:

    Is BNSF hauling oil from North Dakota? If so, how much is Buffett making from it? Is he behind the scenes funding the opposition to the Keystone Pipeline?

  • Report this Comment On June 22, 2014, at 11:16 PM, yardomd wrote:

    BRK bought BNSF to carry coal for power generation, because oil prices were high and nuclear disasters happened. After the oil boom they simply switched from coal to oil for cargo. Even after Keystone pipeline comes on line, BNSF will have plenty of goods to transport.

  • Report this Comment On June 26, 2014, at 10:25 AM, petersimmons72 wrote:

    If you have a multi-billion dollar business moving oil, then OF COURSE you are opposed to a pipeline.

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Patrick Morris

After a few stints in banking and corporate finance, Patrick joined the Motley Fool as a writer covering the financial sector. He's scaled back his everyday writing a bit, but he's always happy to opine on the latest headline news surrounding Berkshire Hathaway, Warren Buffett and all things personal finance.

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