Do You Really Want to Invest Like Buffett?

November 10, 2009

By Neil George, Contributing Editor, InvestorPlace

Few can really top Warren Buffett when it comes to the game of investing, where the one with the most cash at the end is the winner. And right now while he's number 2 on the list of the Forbes 400 with $40 billion piled up - he's poorer than he was from the prior year's score card of the wealthiest in the US.

Should investors have the gall to kick him when he's already smarting from losing some of his billions? Well, perhaps if you invest in Berkshire Hathaway (BRK-A).

Investors following the sage's advice and putting their hard-earned cash to work have lost over 8.3% over the past 12 months. And even worse - they've given up the opportunity to have gained from the general stock market, as the S&P 500 is up over 21% for the same period. Heck, even cash did much better, with U.S. T-bills tacking up a return of over 4.6%.

Perhaps we should give the guy a bit of slack. After all, the past year was an extraordinary one filled with uncertainty and destruction in nearly all facets of the markets.

Why Berkshire is One of 10 Expensive Stocks Worth Every Penny

Unfortunately, Berkshire Hathaway's record over the past five years isn't much better. The average annual return for that period is only 4.2%. And sure, that tops the S&P with an average annual return of just 0.3% over the same period, but it still trails cash, with U.S. T-bills earning an average of over 5.1% with a whole lot less risk and volatility.

The trouble, of course, with Berkshire isn't perhaps Buffett or the other managers of the company making horrible calls, but rather that the company is so big that it can't invest like it did when it all began.

How Buffett Started

That was back in 1956 when Warren Buffett formed Buffett Partnership and invested in solid, if not boring, cash-producing businesses. That led to his acquisition of Berkshire Hathaway, which was then a textile manufacturer. It was not that many more years when in 1969, Buffett moved to dissolve the partnership. He claimed the market was too expensive, and that there wasn't anywhere to go with the cash that would benefit the limited partners.

He kept the Berkshire operation and turned the public company into a new investment vehicle and continued to track down new investments if only on a smaller scale.

If you look at the early history of the Berkshire Hathaway deals, you can see how Buffett made his billions. He did it not by buying into mega deals of whole corporations, but rather smaller companies that fit well into his understanding of businesses that are focused on heavy cash generation with less need of capital investment or product research and development.

This is where See's Candies, Nebraska Furniture Mart and Kirby Vacuum Cleaners came in. Smaller, boring businesses that were profitable and generated hordes of cash for Berkshire Hathaway to re-invest.

This brings up the recent deal for Burlington Northern (BNI) - the biggest ever for Berkshire Hathaway and Buffett. The deal was done reportedly in about 10 days, including 15 minutes to get a positive nod from Burlington's board.

For $100 a share and taking some $10 billion in debt, amounting to some $36+ billion dollars, Berkshire will get the rest of the 77.4% that it didn't already own.

That, of course, was a hefty premium of 33% when the deal was announced. Now comes the fallout, as the ratings agencies are beginning to whine that Berkshire's AAA/Aa2 ratings might well be lowered.

While it's not hard to see the value in a company that has been able to control competition in its key routes and maintains a nice steady stream of revenue gains even as the economy has dropped.

And that's resulted in a stream of productive years for investors in Burlington. Indeed, Burlington shareholders have outearned Berkshire shareholders by multiple fold, with the past five years generating an average annual return of over 13.3% just up to the announcement of Buffett's bid.

Can You Copy Buffett's Investment Strategy?

But rather than heralding Buffett's rail deal, perhaps you'd be better served to buy into what Buffett would have bought if his firm was a lot smaller.

Rail is tough business, particularly with softer manufacturing. Carloads in the U.S. rail market are down some 13.7%. But that doesn't tell the whole story of the rail market. Rail caries a variety of freight, ranging from dry-bulk commodities like coal and grains to packaged product often in trailers and containers. Trailer loads are down over 32%, while containers are only running lower by 5.4%.

This shows that if you're in the right markets - such as in grains, which are actually running up by nearly 10%, you can still keep rolling the cash into your coffers.

While most are now eyeballing Burlington Northern's peers in the Class 1 railroad market and making their cases for investing like Buffett, I recommend taking another tack that's more like Buffett of old.

Because if you're really a student of Buffett - you know that it's all about the steady cash flows -- not about making a bet on the markets or the economy.

Best Buffett-Like Investment Now

This is where Pittsburgh & West Virginia Railroad (PW) comes in. It would've been the perfect old-time Berkshire buy.

Rather than operating a railroad, Pittsburgh & West Virginia simply owns the land and rail lines and exacts a toll on the use. And that toll keeps coming in day after day, year after year.

The company is structured as a REIT (real estate investment trust) and collects the tolls in the form of very long term leases, primarily to Norfolk & Western Railway Company, which is part of Norfolk Southern (NSC) and pays out the lion's share of the proceeds every quarter, amounting to a current yield of 4.9%.

More importantly, while the companies in the general railroad market continue to fluctuate with the constant ups and downs of the stock market and the economy, Pittsburgh & West Virginia pretty much keeps rolling along, sure and solid.

No debt and little operating risk, along with that nice, steady cash flow supporting the steady dividend has resulted in an average annual return of over 10.8% for the past 10 years - all during plenty of booms and busts of the S&P 500 and Berkshire Hathaway shares.

But with only 1.5 million shares outstanding, it's too small for the current Berkshire. But PW is just right for individual investors looking to put a steady cash generator with low volatility into their retirement portfolios for years to come.