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Rupert Hargreaves
Rupert Hargreaves
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Warren Buffett on Berkshire's Shift to Capital-Intensive Businesses

Buffett's thoughts on his BNSF and MidAmerican deals

December 04, 2019 | About:

A notable development in Berkshire Hathaway's  (NYSE:BRK.A)(NYSE:BRK.B) business and equity portfolio over the past several decades has been its transition away from low capital-intensive businesses into high capital-intensitive businesses such as railroads and utilities.

One of Warren Buffett (Trades, Portfolio)'s most profitable investments of all time, in terms of return on invested capital, is See's Candies. Over the years, this business has required less than $50 million worth of capital, but has thrown off more than $2 billion in profits.

Buffett has called these sorts of companies "wonderful businesses" because they don't soak up capital and they throw off a lot of cash for their investors.

This cash can then be redeployed into other investments without having to worry about capital spending requirements at the original business. For example, See's does not have to upgrade its equipment every year as some commodity businesses must due to wear and tear.

So why has Berkshire moved away from that sort of investment in recent decades, deploying tens of billions of dollars in companies like MidAmerican Energy and BNSF? The Oracle of Omaha explained this shift at the 2010 Berkshire Hathaway annual meeting of shareholders.

Deploying lots of capital

The main problem Buffett has encountered over the past decade or so is Berkshire's size. With $10 billion operating income in 2018, the group is awash with cash that it needs to invest.

Unfortunately, as Buffett explained nine years ago, "The world is not set up so that you can reinvest tens of billions of dollars, and many, many tens over time, and get huge returns. It just doesn't happen."

The company tries to acquire any fantastic businesses it finds trading at attractive prices, but putting all of the money that the group generates every year into these sorts of companies in an intelligent way is becoming harder and harder as the conglomerate continues to grow.

According to Buffett, Berkshire has turned to capital intensive businesses as a direct result:

"The world is not set up so that you can reinvest tens of billions of dollars, and many, many tens over time, and get huge returns. It just doesn't happen. And we try to spell that out as carefully as we can so that the shareholders will understand our limitations.

Now, you could say, 'Well, then aren't you better off paying it out?' We're not better off paying it out as long as we can translate, as you mentioned, the discounted value of future cash generation. If we can translate it into a little something more than a dollar of present value, we'll keep looking for ways to do that. In our judgment, we did that with BNSF, but the scorecard will be written on that in 10 or 20 years. We did it with MidAmerican Energy.

We went into a business, very capital intensive, and so far, we've done very well, in terms of compounding equity. But it can't be a Coca-Cola, in terms of a basic business where you really don't need very much capital, if any, hardly. And you can keep growing the business if you're lucky, if you've got a growing business.

See's is not a growing business. It's a wonderful business, but it doesn't translate itself around the world like something like Coca-Cola would."

Luckily, the average investor does not have the same problem. Nevertheless, we can learn a lot from Buffett's thoughts here. Every investor should be trying to deploy capital into wonderful businesses at attractive prices intelligently.

If these opportunities don't exist, then you can either sit on the sidelines or find other opportunities that could offer a lower rate of return, as long as the investment's value can grow over time.

Disclosure: The author owns shares of Berkshire Hathaway.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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