Although I have tremendous respect for Warren Buffett and believe his criticism of the Kraft-Cadbury transaction was well-founded, I am fearful that his purchase of Burlington Northern was not in his shareholders’ best interests.
As Buffett surely knows, shrewd investing requires a healthy dose of scepticism. Every word that comes out of his mouth should not be looked upon as prophecy. For the investment community and the media alike, Buffett has been canonized into value investing sainthood. Investors refuse to criticise him – after all he’s been right more often than wrong – and so we only get positive “puff” pieces from the media.
On the rare occasion when Berkshire Hathaway stock declines more than the market, an article appears asserting that “Buffett has lost his magic touch.” Those articles, however, are usually followed by stellar performance by Berkshire. Though Buffett deserves admiration for the incredible returns he has achieved for his investors over the last half-century, he should not be canonized.
Sometimes he is wrong, and when that happens Berkshire’s investors pay the price.
Buffett was right to criticise Kraft’s decision to buy a fairly valued (or overvalued) Cadbury at 22 times earnings (over the past 15 years, its average price-to-earnings ratio has been 21), using Kraft’s undervalued stock. Cadbury runs a global, non-cyclical confectionary business that, if properly managed, should have a very high return on capital. Buffett, a shareholder of Kraft, was very public about his dismay – he said he felt poorer when Cadbury accepted Kraft’s increased offer.
Though I agree with Buffett’s assessment of the Kraft-Cadbury deal, I fear that investors and media are completely ignoring Berkshire’s own, $30-billion-plus acquisition of a very cyclical, capital-intensive, not terrifically high-return-on-capital business – Burlington Northern. It is a railroad for which Berkshire will lay out 18 times earnings. To make matters worse, part of the deal will be financed by issuing what Buffett recently called “cheap” Berkshire stock.
Burlington stock is not cheap; it is fairly priced at best – over last 15 years its average P/E was 15. Owning Burlington Northern will not make Buffett’s railroad business more valuable. There is little value to be unlocked in this business, especially if Buffett practices his usual hands-off approach. At least in case of Cadbury, there is room to unlock value if Cadbury’s business is managed properly. It should have much higher return on capital. Is Kraft the right “unlocker” of value? I am not sure. After all, it has struggled to manage its own business well.
Buffett said many of the right words – “I am betting on the recovery of the US economy” – but rays of hypocrisy shine through his statements about Kraft and his actions regarding Burlington Northern. He felt “poorer” when Kraft made the acquisition. Well, Berkshire’s shareholders should feel poorer, too.
Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007). To receive Vitaliy’s future articles my email, click here.
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