Buffett’s train set

So why did Warren Buffett spend $26 billion on a railroad (BNSF) – seemingly a rather unexciting target for a 31% premium. The WSJ reports that

Mr. Buffett is betting that in an era of high fuel costs, railroads will perform better than the trucking industry. More broadly, the investment is a wager on the long-term strength of the U.S. economy as it emerges from a prolonged recession. As U.S. commerce recovers, so too will demand to move goods around the country.

It's also nice that there's no Google of transportation waiting to replace railroads.

But Jason Zweig has another explanation:

Mr. (Benjamin) Graham taught Mr. Buffett that at the heart of the relationship between management and shareholders is a profound conflict of interest. Managers, Mr. Graham believed, will always want to pile up cash to protect themselves in case they make mistakes. But that cash belongs to the shareholders, who may be able to put it to better use than the company's managers. * * *

Because of Mr. Buffett's extraordinary skill at picking stocks and buying lucrative businesses, Berkshire consistently generates far more cash than even Mr. Buffett thinks he can put to productive use. * * *

Mr. Buffett would rather not resort to the simplest way of solving this problem -- paying excess cash out to shareholders in the form of a dividend. Since he owns roughly 26% of Berkshire's shares, a cash dividend would saddle Mr. Buffett with one of the largest personal-income tax bills in American history. That's not the kind of thing at which he likes to excel. Mr. Buffett's reluctance to pay a dividend leaves him with little choice but to buy big companies outright. * * *

Like Burlington Northern itself, Berkshire's shares aren't quite a steal. Mr. Buffett is putting tens of billions of dollars into a company that he thinks has only moderate growth prospects. That implies that the market as a whole isn't a steal, or he would have put the money elsewhere. But Mr. Buffett has built an investing bulwark -- and an industrial conglomerate. Berkshire is likely to survive any storm, but whether it can continue to beat the market by such wide margins is another story.

Maybe investors will come to recognize that even somebody like Warren Buffett can entail agency costs. One way to address these costs is to turn Berkshire into an uncorporation that promises investors greater access to the cash.

So if Buffett ever tires of Benjamin Graham (or wants to see Graham's lessons applied to modern firms) here is some reading I would suggest.

Comments

[David Q.]

While unincorporation could be a very nice solution to avoid a large tax bill, there is another, and perhaps easier solution, if Congress would allow it to happen - simply, provide a credit for any tax on dividends.

The U.S. is an anomaly in this respect. Many other countries either 1) do not tax dividends, or 2) provide a hefty credit to the dividends taxed. As such, incorporation is not necessarily seen as disadvantageous. The benefits of unincorporation are not simply the tax benefit, but also the flexibility that it provides managers.

If the U.S. wants to encourage incorporation, perhaps because the corporate form specifically attempts to deal with agency costs through traditional fiduciary duties, and eliminate inefficiencies, e.g. hoarding, then eliminating the tax on dividends seems very very appropriate.