Wednesday, November 4, 2009

Behind the Decision, a Lesson From a Mentor

By Jason Zweig
Warren Buffett's purchase of Burlington Northern Santa Fe Corp. is the newest chapter in the oldest story of his professional life.

Mr. Buffett's mentor, the pioneering "value" investor Benjamin Graham, trafficked for decades in railroad stocks and bonds. In the early 1950s, at the outset of his career, Mr. Buffett read every page in Moody's voluminous transportation manuals -- twice, to make sure he didn't miss anything. Working at Mr. Graham's fund, Graham-Newman Corp., Mr. Buffett analyzed a portfolio with 21% to 36% of its assets in railroads.

But there is a more subtle side to the story. Mr. Graham taught Mr. Buffett that at the heart of the relationship between management and shareholders is a profound conflict of interest. Managers, Mr. Graham believed, will always want to pile up cash to protect themselves in case they make mistakes. But that cash belongs to the shareholders, who may be able to put it to better use than the company's managers.

Graham also highlighted a painful paradox: The better the business and the more skilled its managers, the greater its profits, causing cash to pile up to unreasonable levels. And, to Mr. Buffett's own chronic discomfort, he and Berkshire Hathaway are living proof of Mr. Graham's paradox. Because of Mr. Buffett's extraordinary skill at picking stocks and buying lucrative businesses, Berkshire consistently generates far more cash than even Mr. Buffett thinks he can put to productive use.


Mr. Buffett would rather not resort to the simplest way of solving this problem -- paying excess cash out to shareholders in the form of a dividend. Since he owns roughly 26% of Berkshire's shares, a cash dividend would saddle Mr. Buffett with one of the largest personal-income tax bills in American history. That's not the kind of thing at which he likes to excel. Mr. Buffett's reluctance to pay a dividend leaves him with little choice but to buy big companies outright.


As a result of the Burlington Northern deal, Berkshire's Class B shares will split 50-for-1, which would knock its share price down from $3,300 to $65. That puts the shares, for the first time in years, within psychological reach of most investors (who have long balked at Berkshire's high per-share price).

Like Burlington Northern itself, Berkshire's shares aren't quite a steal. Mr. Buffett is putting tens of billions of dollars into a company that he thinks has only moderate growth prospects. That implies that the market as a whole isn't a steal, or he would have put the money elsewhere. But Mr. Buffett has built an investing bulwark -- and an industrial conglomerate. Berkshire is likely to survive any storm, but whether it can continue to beat the market by such wide margins is another story.