Sunday, May 4

Week 148 - Utilities and Railroads

Situation: We all know that it’s not a good idea to invest in a company that has high fixed costs AND variable costs that are both high and unpredictable (e.g. energy sources). Prominent examples of such companies are railroads and electric utilities. While those impediments to investing normally would make it difficult to attract financing at a reasonable cost, politicians recognize that rail transportation and electricity are essential public services. As a result, these industries have come to be tightly regulated. In return, company shareholders know they’ll get a return on equity that is 9% or greater, their bonds will have a degree of government backing, and rules against monopoly power will be waived. 

Importantly, Warren Buffett has come to see that the advantages of investing in rail transportation and electricity producers outweigh the disadvantages. Berkshire Hathaway now owns the largest railroad in the country (Burlington Northern Sante Fe), as well as what will soon be the largest electric utility (MidAmerican Energy). Both subsidiaries are growing at a remarkable pace, in large part because Mr. Buffett requires them to invest 100% of their free cash flow in expansion (i.e., no dividends are paid to the parent company). In Berkshire’s recently issued annual report, we see that a whopping 78% of its pre-tax earnings came from those two subsidiaries. We also see that Mr. Buffett considers them to be so similar that he groups their results together.  

To participate in the smoothly growing total returns that reward investors in the leading electric utility and railroad companies, you can simply invest in Berkshire Hathaway B shares (BRK-B), priced at around $125, or you can consider the 8 companies in this week’s Table. Those 8 companies were picked because of a) placement on Barron’s 500 list of companies with the best sales and cash flow growth, and b) having an “A-” or better S&P rating on their long-term debt. Six of the 8 are Dividend Achievers with 10 or more years of dividend growth. The two exceptions will become Dividend Achievers in a little less than one year (D) or a little less than 3 years (UNP). We list Canadian National Railway (CNI) as a Dividend Achiever even though S&P doesn’t list it (due to its being based outside the US) because its record of dividend growth qualifies it for inclusion.

Bottom Line: Don’t overlook electric utilities and railroads. Yes, both are heavily regulated by federal, state and local governments but politicians have learned not to interfere beyond making sure that these monopolies don’t harm, neglect, or take advantage of their customers. Total returns for the 8 companies in the Table are expected to grow at 12.4%/yr (Column G + Column H in the Table), consistent with having grown at 12.9%/yr over the past two market cycles, i.e., the time since the S&P 500 Index peaked at 1520.77 on 9/1/2000. Over that same period (ending in March 2014), the S&P 500 Index with dividends reinvested grew at a rate of only 3.6%/yr . The 8 stocks in the Table managed their far superior growth while losing only 18.8% during the 18-month Lehman Panic (Column D in the Table), whereas, the low cost Vanguard 500 Index Fund lost 46.5% (Line 20 in the Table). This stunning difference in long-term risk persists to the present day, given the current difference in the 5-yr Beta statistic: 0.36 vs. 1.00 (Column I in the Table). You decide.  

Risk Rating: 3. 

Full Disclosure: I happily own stock in NextEra Energy, Berkshire Hathaway, and Canadian National Railway.

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