Burlington
Northern Santa Fe (“Burlington”)
pre-edited
submission by
David Leoy,
Business Analyst, Singapore
(1.) Name the business' competitive advantages
Having a strong moat to keep
competitors at bay has been a consistent pre-condition
in Buffett’s past investments.The
impregnable franchise of Burlington is very
apparent. Founded in 1961, Burlington currently
owns over 32,000 miles of track in the United
States. It also holds over 6,700 locomotives and
85,000 freight cars. This presents a formidable
barrier to entry because any competitor would
have to fork out multi billions in capital
expenditure to replicate Burlington’s
existing set up. There is also heavy ongoing
maintenance capex, estimated to be US$2.6 billion
annually. Due to the moat around Burlington's
business, it has been remarked that the company
could be poorly run, but each time the ocean
freight rate differential forced export grain to
the Pacific Northwest ports, Burlington could not
help but profit from the shift. This is in line
with Buffett's remarks which often extorted
investors to "invest in a business that even
a fool can run".
Buffett’s purchase is
also perhaps a bet that, with the burgeoning
deficit, the US government will not be spending
enough to repair and expand the country's
infrastructure.This could then lead to greater
highway congestion and consequently force traffic
onto railroads. Already the largest inter-modal
freight hauler in the sector, Burlington is well
positioned to further benefit from the shift of
freight from an all highway movement to inter-modal.
In the latter system, truckers do the pick up and
delivery in the last mile while trailers and
containers travel long haul by rail.
(2.) Are they
sustainable for the next 10 years
Despite its debt woes,
Buffett has reiterated his optimism for
America’s future. Burlington represents his
bet on the economic future of America because it
is the workhorse serving more of the nation's
major grain producing regions than any other
railroad. Besides being the largest transporter
of beer and wine by rail in the United States,
Burlington transports sufficient canned beverages
to supply every resident of New York, Chicago and
Los Angeles with one beverage a day for nearly
one year. It also hauls many industrial goods
such as lumber, iron and steel across America.
Hence, as long as America thrives and consumes,
Burlington will continue to do well.
In
a likely era of heightened inflation and elevated
oil prices, railroads are preferred over long-haul
trucking. Looking ahead, fuel prices are likely
to remain high due to scarcity of supply and
higher extraction costs, maintaining rail’s
cost edge. This would also in turn compel America
into using and transporting more coal. Currently,
more than 10 per cent of the electricity produced
in the country, enough to power one out of every
ten homes, is already being generated from coal
hauled by Burlington. Furthermore, as the world
becomes more environmentally conscious,
regulatory policies are increasingly more
favourable for the railroad sector. Rail is the
most environmentally friendly form of surface
transportation. A government study had revealed
that railroads are up to 5.5 times more fuel
efficient than trucks in carrying goods. Hence,
regulators are expected to be focused on reducing
commercial truck traffic and channelling them
onto rail. This is because the latter generates a
quarter as much in greenhouse gases.
Sample Chapter,
After Final Editing:
Burlington
Northern Santa Fe Corp. competitive advantage
Bud
Labitan with David Leoy, Business Analyst,
Singapore
The
highlight of 2010 was acquisition of BNSF. Said
Buffett, “It now appears that owning this
railroad will increase Berkshire’s
“normal” earning power by nearly 40%
pre-tax and by well over 30% after-tax. Making
this purchase increased our share count by 6% and
used $22 billion of cash. Since we’ve
quickly replenished the cash, the economics of
this transaction have turned out very well.”
Charlie
Munger, Vice Chairman of Berkshire Hathaway,
commented, “we used to not like them (railroads)
because they needed large amounts of capital, had
tough unions, and stiff competition from the
trucking business. The paradigm had shifted. Now
the railroad industry has a competitive advantage
in energy use efficiency and double-stacking
freight.”
Railroads
now have major cost and environmental advantages
over their main competitor, trucking. Last year
BNSF moved each ton of freight it carried a
record 500 miles on a single gallon of diesel
fuel. That is three times more fuel-efficient
than trucking. Our country gains because of
reduced greenhouse emissions and a smaller need
for imported oil. Over time, the movement of
goods in the United States will increase, and
BNSF should get its full share of the gain. The
railroad will need to invest massively to bring
about this growth, but no one is better situated
than Berkshire to supply the funds required.
Railroads
profit from longer hauls. They have sold or
leased short runs to independent short-line
railroads, which pay a percentage of the haul to
the major railroads. So, the major railroads have
eliminated the less profitable short-line
business. The Staggers Act in 1980 deregulated
railroads and allowed them to set rates to
compete with trucking. Railroad managements
negotiated with the unions, resulting in standard
trains having two rather than five people on
board. And, railroad maintenance costs have been
lowered by automation and mechanization.
Low-sulfur
coal mined in Powder River, Wyoming is
transported to to electric plants around the
country. Wyoming coal is also shipped to
Birmingham, Alabama three times a week in 132
coal gondola cars. This train has three big
engines on the front and two pushing engines in
the back. After unloading in Birmingham, and
without turning the unit around, the two rear
engines lead the train back to Powder River.
Charlie
Munger admitted: “We did finally change our
minds and invested. We finally realized that
railroads now have a huge competitive advantage,
with double-stacked railcars, guided by computers,
moving more and more production from China, etc.
They have a big advantage over truckers.”
Burlington
currently owns over 32,000 miles of track in the
United States. It also holds over 6,700
locomotives and 85,000 freight cars. This is a
formidable barrier to entry because any
competitor would have to spend multi billions in
capital expenditure to replicate the BNSF system.
There is also heavy ongoing maintenance capital
expenditures, estimated to be US$2.6 billion
annually.
Due
to the moat around Burlington's business, it has
been said that the company could be poorly run,
but each time the ocean freight rate differential
forces export grain to the Pacific Northwest
ports, Burlington can profit from the shift.
The
US government may not spend enough to repair and
expand the country's infrastructure. This could
then lead to greater highway congestion and force
traffic onto railroads. Already the largest inter-modal
freight hauler in the sector, Burlington is well
positioned to further benefit from the shift of
freight from highway movement to inter-modal. In
the latter system, truckers do the pick up and
delivery in the last mile while trailers and
containers travel long haul by rail.
Are
the competitive advantages sustainable for the
next 10 years? Despite its debt, Buffett has
reiterated his optimism for America’s future.
Burlington represents his “All in
wager” on the economic future of America
because it is the workhorse serving more of the
nation's major grain producing regions than any
other railroad. Besides being the largest
transporter of beer and wine by rail in the
United States, Burlington transports many
industrial goods such as lumber, iron and steel
across America. Hence, as long as America thrives
and consumes, Burlington will continue to do well.
In a
likely era of heightened inflation and elevated
oil prices, railroads are preferred over long-haul
trucking. Looking ahead, fuel prices are likely
to remain high due to scarcity of supply and
higher extraction costs. This maintains
rail’s cost edge. This could also compel
America into using and transporting more coal.
Currently, more than 10 per cent of the
electricity produced in the country, enough to
power one out of every ten homes, is being
generated from coal hauled by Burlington.
Furthermore, as the world becomes more
environmentally conscious, regulatory policies
are tilting more favourably towards the railroad
sector. Rail is a more environmentally efficient
form of surface transportation. Rail generates
only a quarter as much in greenhouse gases. Since
a government study revealed that railroads are
much more fuel efficient than trucks in carrying
goods, regulators are expected to focus on
reducing commercial truck traffic and channelling
them onto rail.
The
increasing consumption of bio-fuels such as
ethanol will benefit railways too. Ethanol fuel
production in the US has been growing over 30 per
cent in recent years. Production hit 13 billion
gallons in end 2010. Production capacity and
demand for ethanol is likely to further increase
with the push towards the use of cleaner energy.
Given that ethanol cannot be transported in
pipelines, rails will shoulder a substantial
portion of the load. The BNSF system has three
transcontinental routes. And, BNSF has the
best route from Long Beach, California, to
Chicago, Illinois.
Introduction
Charlie
Munger said, “Let’s go for the
wonderful business.” So, after years of
buying “bargain-purchase" follies,
Warren Buffett and Charlie Munger realized
that it is much better to buy a wonderful company
at a fair price than a fair company at a
wonderful price. Now, when buying companies or
common stocks, they look for first-class
businesses accompanied by first-class managements.
What
makes a first-class business wonderful? It must
have one or more economic moats.
One
of the oldest moats surrounded the ancient
Egyptian settlement of Buhen, on the West bank of
the Nile River. During the medieval period, the
kings of Europe would build wide and deep
trenches filled with water around their castles.
These moats were built as single or double
protective barriers against invading armies. In
business, we think of economic barriers that can
both defend and injure the invading competition.
Munger observed that capitalism is a pretty
brutal place. Yet, some good businesses can
survive a little bad management. Warren Buffett
said “A truly great business must have an
enduring ‘moat’ that protects excellent
returns on invested capital.”
Moats
is designed as a learning resource for investors,
students, and managers of business. This book is
about the competitive advantages of businesses
that Warren Buffett and Charlie Munger bought for
Berkshire Hathaway. (NYSE: BRK.A, BRK.B). Most of
these businesses are wholly owned subsidiaries. A
handful of them are partially owned through stock
(equity) investments. Imagine these competitive
advantages as protective moats around each
economic castle. Will these economic moats endure
over time? Over time, each customer makes up a
part of that answer. Charlie Munger stated it
this way: “How do you compete against a true
fanatic? You can only try to build the best
possible moat and continuously attempt to widen
it.”
The
information within this book comes from multiple
online sources listed in the Appendix. The most
important sources come from each business’
publications and the annual letters of Warren
Buffett to the shareholders of Berkshire Hathaway.
Other pieces of information were found by the
many volunteers and students listed in the
Appendix.
The
research volunteers and contributors to this book
were asked two basic questions. First, what are
the competitive advantages of the business you
are looking at? Secondly, are these advantages
sustainable for the next ten years?
When
I posted this offer out on the web, I was pleased
to welcome many enthusiastic and knowledgeable
volunteers. While much of my research was already
compiled, I needed to test my ideas against
someone else. So, I thank each and every one of
the contributors listed at the Moats website here:
http://www.frips.com/book.htm
I
extend a special thanks to Professor Phani Tej
Adidam, Ph.D. who is the Executive Education
Professor of Business Administration, and Chair,
Department of Marketing and Management, and
Director, CBA International Initiatives at
University of Nebraska at Omaha. Professor
Adidam’s MBA students of 2011 have
contributed valuable ideas to many of these
chapters.
Thank
you Richard Konrad, CFA, of Value Architects
Asset Management. Rick has been an insightful
contributor to several chapters. Thank you Dr.
Maulik Suthar of Gujarat, India. Maulik has been
a thoughtful contributor to several chapters, and
an enthusiastic supporter of this project. Thank
you Scott Thompson, MBA for sharing your thoughts,
analysis, and feedback.
This
book is about the competitive advantages of 70 of
the many businesses that Warren Buffett and
Charlie Munger bought for Berkshire Hathaway. Why
did I focus on 70? I took the names of the
businesses listed on business website’s link
to subsidiaries, and added a few of their largest
stock investments. My intent was to study the
economic moats and see which ones are growing and
which ones are shrinking.
Having
a “Sustainable Competitive Advantage”
means customers keep coming back to repurchase.
The two major areas of competitive advantage are:
1. a cost advantage, and 2. a differentiation
advantage. While the marketing mix teaches us to
think about the product, price, place, and
promotions, this all comes together in the mind
of the potential customer. The customer may or
may not perceive these two general areas of
advantage. This book refers to them as a
“cost” and “special”
advantages. I simplify by substituting the word
“special” for differentiation.
Over
the years, Warren Buffett and Charlie Munger
found wonderful businesses by asking a lot of
questions. What is the nature of each business?
Can we predict it with a high degree of accuracy?
Can we imagine a moat around each economic castle?
Will this moat be enduring? Is there something
special here for our customers, or is this
advantage eroding?
Since
the nature of capitalism is competition, a
successful business needs to have “something
special” in order to lead the pack and fend
off present and potential competitors. It needs a
barrier to entry. Sustainable Competitive
Advantage is also called “favorable long-term
prospects” or “enduring economic
advantages.” It comes from things that make
a business difficult to copy or enter. A brand is
such a barrier because it represents something
unique and valued in the mind of a customer that
promotes customer loyalty. A valuable patent or
trademark can also give a business a period of
protected advantage, acting as a barrier to entry.
Warren
Buffett and Charlie Munger added to Ben Graham's
foundation of bargain hunting by looking for a
business with a big protective moat around it.
Buffett and Munger look for something special in
peoples’ minds such as: Lower Cost of
Production, Brands, Economies of Scale, Patented
Technology, Location, Distribution System,
Specialized Services, Network, Regional
Monopolies and Intangible Assets that create
higher switching costs and a barrier to entry.
So
what makes one business thrive better than
another business? There must be something special.
In one example, Charlie Munger recommended the
autobiography of Les Schwab “Les Schwab
Pride in Performance: Keep It Going.”
According to Munger, “Schwab ran tire shops
in the Midwest and made a fortune by being shrewd
in a tough business by having good systems.”
That was Schwab’s specialty.
At
GEICO insurance, the cost advantage present is a
barrier for competitors. Can they match GEICO in
cost or service? Buffett stated that GEICO's
direct marketing gave it an enormous cost
advantage over competitors that sold through
agents. What about size and capital rating? Well,
GEICO certainly has strong backing, and Berkshire
Hathaway’s other insurance and reinsurance
operations also benefit from the size, rating,
and “time tested” operational soundness
of its business organization.
This
ability to endure over time, in good times and in
bad, and continue to earn a solid profit is an
important competitive advantage that helps make a
company a “wonderful business.”
Sometimes, that comes about because of decent
economics plus superior managements who work to
build a stronger moat in the product or service
by creating a special “brand”
impression.
Talking
about less competitive and weaker businesses,
Warren Buffett said, “In many industries,
differentiation simply can’t be made
meaningful. A few producers in such industries
may consistently do well if they have a cost
advantage that is both wide and sustainable.”
However, these are a few exceptional businesses.
In many industries, such enduring winners do not
exist. So, for the great majority of businesses
selling “commodity” products, Buffett
believes that a depressing equation of poor
business economics prevails. In his view, “a
persistent over-capacity without administered
prices (or costs) equals poor profitability.”
Buffett
and Munger like strong brands like those of Coke,
Gillette, and Kraft. These companies have
increased their worldwide shares of market in
recent years. Their brand names, the attributes
of their products, and the strength of their
distribution systems gives them competitive
advantage. So what does this sustainable
competitive advantage look like in numbers? Take
a look at their 5-10 year records of FCF (Free
Cash Flow) and ROE (Return on Equity) compared to
those of competing businesses.
Consider
why the Coca-Cola Company is such a good business
from an investor’s point of view. Both Coke
and Pepsi make products we enjoy. As an investor,
I prefer the Coca-Cola Company. One reason is the
amount of FCF generated for every sale.
Buffett
also commented on the competitive arena of
selling insurance. He said, “Insurers will
always need huge amounts of reinsurance
protection for marine and aviation disasters as
well as for natural catastrophes. In the 1980s
much of this reinsurance was supplied by
’innocents’ - that is, by insurers that
did not understand the risks of the business -
but they have now been financially burned beyond
recognition.” In the world of marketing
super-catastrophe insurance, Buffett said
Berkshire Hathaway enjoys a significant
competitive advantage because of its premier
financial strength.
How
does practical competitive advantage tie in with
current academic thought? In his book,
“Competition Demystified”, Bruce
Greenwald of Columbia University presented a new
and simplified approach to business strategy. The
conventional approach to strategy taught in
business schools is based on Michael
Porter’s work. In Porter’s model,
students can get lost in a sophisticated model of
a business’ competitors, suppliers, buyers,
substitutes, and other players.
Greenwald
warns us to not lose sight of the big question,
“Are there barriers to entry that allow us
to do things that other firms cannot? “ Then,
after establishing the importance of barriers to
entry, Greenwald and Kahn argue that there are
really only three sustainable competitive
advantages; 1. Supply. A company has this edge
when it controls an important resource: A company
may have a proprietary technology that is
protected by a patent. 2. Demand. A company can
control a market because customers are loyal to
it, either out of habit - to a brand name, for
example - or because the cost of switching to a
different product is too high. 3. Economies of
scale. If your operating costs remain fixed while
output increases, you can gain a significant edge
because you can offer your product at lower cost
without sacrificing profit margins.
Wal-Mart
has shown its power in scale, and Charlie Munger
put it this way: “Kellogg's and Campbell's
moats have also shrunk due to the increased
buying power of supermarkets and companies like
Wal-Mart. The muscle power of Wal-Mart and Costco
has increased dramatically.”
According
to Professor Greenwald, the value of such a
strong brand barrier can be estimated. It is
about equal to its “difficult for competitor
to match” reproduction costs.
In
order to insure success, the operation of these
good businesses must continue to be in the hands
of first-class, able, trustworthy, and
experienced managers. Focus on whether these
competitive advantages are due to power in demand,
supply, or economies of scale. However, in this
book, we simplify this even more into
“cost” and/or “special”
advantages. Then, we discuss our impressions of
whether their moats will endure over time.
Warren
Buffett and Charlie Munger look for companies
that have a) a business they understand; b)
favorable long-term economics; c) able and
trustworthy management; and d) a sensible price
tag. They like to buy the whole business or, if
management is their partner, at least 80%. When
control-type purchases of quality aren’t
available, they are also happy to simply buy
small portions of great businesses. Buffett said
that it is better to have a part interest in the
Hope Diamond than to own all of a rhinestone.
The
dynamics of capitalism guarantee that competitors
will repeatedly assault any business ’castle,
that is earning high returns. Buffett and Munger
believe that a great business must have an
enduring ’moat’ that protects its
excellent returns on invested capital. Strong
barriers such as being the low cost producer (GEICO,
Costco) or possessing powerful world-wide brands
(Coca-Cola, Gillette, American Express, IBM,
Kraft) are essential for sustained success.
Since
business history is filled with companies with
weak and temporary moats, their criteria of
“enduring moat” caused Buffett and
Munger to rule out companies in industries prone
to rapid or continuous change. So, they avoid
investing in technology companies. The chapter on
IBM will explain why they recently invested in
this technology related information solutions
business.
Charlie
Munger said, “How do you compete against a
true fanatic? You can only try to build the best
possible moat and continuously attempt to widen
it.”
See's
taught Buffett and Munger much about the
evaluation of franchises. Both men admit that
they have made significant money because of the
lessons they learned at See's. See’s is a
wonderful business.
In
their talks and writings, they refer to a great
business as a “franchise” or a
“wonderful business.” Buffett wrote:
“An economic franchise arises from a product
or service that: (1) is needed or desired; (2) is
thought by its customers to have no close
substitute and; (3) is not subject to price
regulation. The existence of all three conditions
will be demonstrated by a company's ability to
regularly price its product or service
aggressively and thereby to earn high rates of
return on capital. Moreover, franchises can
tolerate mismanagement. Inept managers may
diminish a franchise's profitability, but they
cannot inflict mortal damage.”
Buffet
and Munger respect able and trustworthy managers.
As you read about these 70 great businesses,
think about the product or service that: (1) is
strongly desired; (2) has no close substitute and;
(3) has pricing power. As Buffett said, “A
moat that must be continuously rebuilt will
eventually be no moat at all. Additionally, this
criterion eliminates the business whose success
depends on having a great manager.”
While this book will help the reader learn
more about enduring competitive advantages, here
is a little reminder about Buffett and
Munger’s contribution to behavioral finance
and value investing. Their Four Filters
innovation help us eliminate many prospects, and
they help us find: “Understandable first-class
businesses, with enduring competitive advantages,
accompanied by first-class managements, available
at a bargain price.”
AUDIO FILES FROM SELECTED CHAPTERS
The MOATS book introduction audio mp3 file: http://www.frips.com/moats.mp3
audio file of Wells Fargo, WFC chapter from MOATS
book:
http://www.frips.com/wfc.mp3
audio file of the Johnson and Johnson chapter
from MOATS:
http://www.frips.com/jnj.mp3
audio file of the Costco chapter in MOATS http://www.frips.com/costco.mp3
audio file of the American Express chapter: http://www.frips.com/axp.mp3
The IBM Chapter from MOATS. Why did Buffett buy
into a technology services
company after so many years? http://www.frips.com/ibm.mp3
Here is a 1 min : 32 sec audio file of Warren
Buffett talking about an
economic castle and its moat http://www.frips.com/wbmoat.mp3
The MOATS book introduction audio mp3 file: http://www.frips.com/moats.mp3
Thank You for mentioning the MOATS book project
on your blog.
Moats will be out on Amazon.com in mid February,
2012.
It is currently available on Lulu.com here: http://www.lulu.com/spotlight/4filters
Major points of interest:
1. MOATS discusses 70 historically profitable
businesses worthy of study.
2. MOATS examines the competitive advantages and
sustainability of each business.
3. Each MOATS chapter has both a Warren Buffett
and a Charlie Munger quote or idea weaved into
the discussion.
4. The MOATS chapter on Lubrizol includes an
estimated valuation based on Free Cash Flows.
5. Each MOATS chapter was checked by two people.
6. Even if you buy the MOATS hardcover edition,
50/70 is $0.72 value per business or chapter.
7. If you liked "Good To Great" by Jim
Collins, you will enjoy MOATS
70 GREAT Berkshire Hathaway Businesses.
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