Imagine for a moment that you were approached by a very wealthy foundation, and they asked you to invest their money. They offer a low asset-based fee, but the assets are so large that it looks like a dream to you. Then they tell you the conditions:
- We want this fund to last forever.
- It must be able to deliver cash proceeds of 5% of assets each year.
- We want it to generate a return that exceeds 7%/year over the long haul.
- It must be able to do this through all environments, regardless of war, including civil war, socialism, famine, plague, etc. This is the “forever fund.”
- And if inflation becomes rampant, over 5%/year, you need to earn the inflation rate plus 2% at minimum.
You gulp, and say, “But sir, that’s impossible. The need for current cash is at odds with a forever mandate. Investing to earn the greater of 7% or 2% more than inflation is an unattainable goal. Who can predict inflation? Away from that, the record of investors during times of extreme societal stress is bad at best.”
He says, “Take it or leave it. Those are the goals.”
You ask for a day to think about it, which he grants. You sit back and think, “How can one assure wealth over generations? I can’t prevent wars, plagues or famines. I can’t even prevent domestic political change. What do I do?”
Then it strikes you. Divide the portfolio in two; one part is there for income and to provide liquidity, the other part is there to provide long-term gains. Since the time horizon is very long term, aim for investments where the sustainable competitive advantage is high, and if possible, where a lot of money can be put to work.
Satisfied, you go to sleep, happy that the problem is solved, but as you dream, Warren Buffett stands in front of you as you accept the management contract. When you wake up, you go sign the deal with the endowment sponsor, but wonder about Buffett. You conclude that it was a bad burger you ate at the Dairy Queen the night before, and let the matter drop.
I thought about writing a negative article regarding Buffett’s purchase of Burlington Northern, but delayed about doing it. I di not jump on the idea, partly out respect for Buffett. I have been both an admirer and critic over the years, so I like to think I am even handed here. Why should I criticize? High valuation paid. The free cash flow yield is low.
But Burlington Northern is very hard to replicate. What would it cost to replicate their transport system? A lot, and in this day of environmentalism, it might be impossible to replicate at any price. Thus for one with the “forever fund” such an investment makes sense. Personally, I would have bought utilities contiguous to my existing holdings, because the same conditions exist there. Steady income plus inflation protection.
So, I don’t fault Buffett for buying Burlington Northern. It makes sense with a very long term view. There might have been better buys among utilities, but he has a lot of money to put to work. He may mop up the utilities next year. Or a cheap large energy company — oh, whoops, he sold that.
When you have a lot of money, the choices get tough. The simple decision is to index, but you didn’t get a lot of money through indexing, so you want to do better. At present, my view would be to buy utility shares and high quality stocks, which have not rallied much, and have defensive characteristics should the market fall. In other eras, real estate might be the investment… but not now.
These companies provide value regardless of the economic circumstances; they are valuable even in bad times. In really bad times, nothing is valuable.