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The Agenda

NRO’s domestic-policy blog, by Reihan Salam.

Thoughts on Warren Buffett, Part II: Is Warren Buffett America’s Carlos Slim?



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In 2009, The New Yorker’s Lawrence Wright published a fascinating profile of Carlos Slim, the controversial Mexican billionaire who had made a splash by investing a large sum of money in the New York Times. At the heart of Slim’s strategy for amassing great wealth has been a systematic effort to build business enterprises with a great deal of pricing power. That is one reason why Slim has been condemned as the “consummate monopolist.” The following is a brief passage that references Warren Buffett, a decidedly uncontroversial and almost universally admired American billionaire: 

Most newspapers in America, like telephone companies in Mexico, operate as semi-monopolies, or what Warren Buffett has labelled “economic franchises”—they offer necessary products or services that are not subject to price regulation and are thought by their customers to have no substitute.

Warren Buffett is known for his love of “economic franchises.” Earlier this year, Andrew Frye and Dakin Campbell of Bloomberg wrote a short piece on Buffett’s views concerning the importance of pricing power:

Warren Buffett, the billionaire chief executive officer of Berkshire Hathaway Inc., said he rates businesses on their ability to raise prices and sometimes doesn’t even consider the people in charge.

“The single most important decision in evaluating a business is pricing power,” Buffett told the Financial Crisis Inquiry Commission in an interview released by the panel last week. “If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

Buffett, 80, accumulated the world’s third-largest personal fortune through a career of stock picks and takeovers. He has bought companies such as railroads and electricity producers, whose pricing power stems from a dearth of competitive options available to clients. Buffett has also built stakes in firms like Coca-Cola Co. and Kraft Foods Inc., which rely on the appeal of their brands to attract and keep customers.

“The extraordinary business does not require good management,” Buffett said in the interview, which was conducted on May 26 in Omaha, Nebraska.

Buffett’s trademark humor comes out a number of times in the article:

“I knew nothing about the management of Moody’s,” said Buffett. “If you own the only newspaper in town, up until the last five years or so, you had pricing power and you didn’t have to go to the office.”

But there is nothing even slightly funny about the formidable pricing power some of Buffett’s companies have built over time:

Burlington Northern Santa Fe, the railroad Buffett bought last year for $26.5 billion, owns more than 30,000 miles of track across the U.S. West connecting producers and distributors of coal, grain and consumer goods. Omaha-based Berkshire’s power company, MidAmerican Energy Holdings Co., sells electricity to homes in the Great Plains and transports natural gas fromWyoming to California.

In the latest issue of Fortune, staff reporter Mina Kimes has written an extraordinary story on the four companies that dominate U.S. rail freight, one of which is Buffett’s Burlington Northern Santa Fe. At the time of the purchase, Buffett memorably said that his acquisition of Burlington Northern Santa Fe was a “bet on the country,” i.e., a bet on the future economic health of the United States. He has said something similar about investments in various large financial institutions, which have enjoyed vast amounts of taxpayer largesse in recent years. 

Even with a weak economy, however, primary commodities have to be moved across the vast American landscape, particularly coal. Recently, Yonah Freemark made the following observation about U.S. freight railroads:

 

Though trucking accounts for a larger percentage of freight shipments in Europe, the U.S. actually moves a larger amount of goods (by ton-mile) by road than its European peers (1.7 million ton-miles versus 1.3 million), despite having a smaller population (310 million vs 380 million). How can this be? In order to consume what we consume, Americans rely on goods that are moved longer distances. And U.S. inhabitants are also larger consumers of material goods that require shipping; indeed, the country’s 6.5 million annual ton-miles of freight dwarf the 3.1 million in Europe.

Most significant perhaps is the American reliance on coal as an energy source; it accounts for almost half of overall power production in this country, compared to about 16% in Europe overall (and even less in some countries like France and Spain). Related is the fact that Europeans simply consume less energy — less than half as much on a per-capita basis and almost as little even in the wealthiest countries like Germany. For historical and logistical reasons, coal can be moved more efficiently by train, which explains a large share of the difference between American and European freight transport patterns. The coal moved by American railroads alone — about 1.5 million ton-miles, representing 23% of American goods movement — is equivalent to about half of all European freight shipments, according to the Harvard study, based on 2000 information.

More recent data suggests that the emphasis of American freight railroads on coal shipments has only become more pronounced, accounting for 47% of tons moved on the railways in 2007. Wyoming, of all states, is the leading state for outbound shipments of freight… because of the coal that originates there.

So the U.S. reliance on an incredibly polluting, inefficient power source has upped the use of trains for freight. But that is no success story in itself, since renewable forms of power production require no forms of material movement to and from production facilities. Less transportation — if not needed — is more efficacy from an economic and environmental perspective. [Emphasis added]

In a sense, Warren Buffett has profited enormously from America’s heavy and durable reliance on coal as an energy source. This could very well be a “bet” on America of a kind — a bet that regulations will cripple the development of domestic shale gas resources and nuclear power, energy sources that are far cleaner and far less likely to deleteriously impact the cognitive development of small children than coal. 

Kimes summarizes the debate over the pricing power of U.S. freight railroads at the start of her story:

Shippers and railroads are natural adversaries, and have been for as long as the iron horse has existed. In the 19th century, farmers banded together to resist railroad power. So potent were the carriers that one, the Pennsylvania Railroad, was cocky enough to enter the oil business against John D. Rockefeller, sparking an epic conflict the likes of which hasn’t been seen again — until today.

It’s a war that pits business against business, and the central charge is one that would’ve been familiar to Rockefeller: monopoly power. Since freight railroads were deregulated in 1980, the number of large, so-called Class I railroads has shrunk from 40 to seven. In truth, there are only four that matter: CSX and Norfolk Southern (NSC) in the East, Union Pacific (UNP) and Burlington Northern Santa Fe in the West. These four superpowers now take in more than 90% of the industry’s revenue. And they’re shielded by a potent advantage: an exemption from key antitrust laws. Not coincidentally, the Big Four’s profits and stock prices have soared; their success was ratified when Warren Buffett’s Berkshire Hathaway (BRKA) purchased Burlington Northern Santa Fe for $26 billion in 2010.

And as she goes on to explain, the railroads enjoy a number of very special protections:

The railroads’ power is amplified by an unparalleled set of antitrust exemptions. The industry’s regulator, the STB, permits several practices that severely restrict competition: The Big Four are allowed to sign secret agreements, known as “paper barriers,” with short-line railroads, in which the small fry agree to funnel all their traffic to just one big railroad. They are also permitted to refuse to connect customers to a competing freight line.

If these long-held, special protections weren’t in place, the Justice Department has said, such practices could violate antitrust law. Indeed, 20 state attorneys general have protested the railroad exemptions. And in 2008 the American Bar Association’s Section on Antitrust Law blasted them as “naked economic protectionism.”

Needless to say, the balance of power between customer and carrier has shifted. “I literally had a railroad employee tell my traffic manager, If you don’t like it, buy your own railroad,” says Bill Auriemma, the president of a small Illinois-based specialty-gas maker. He says his company, Diversified CPC International, now pays rates marked up by around 300%. “There’s an institutional arrogance.”

Even Fortune 500 giants feel powerless. Keith Smith, the chief procurement officer at chemical giant DuPont (DD), says the company used to start contract talks with railroads a year in advance to leave plenty of time for discussion. But after 2004, he says, the railroads were no longer willing to negotiate. “We saw rate increases on average of 100%,” says Smith. “At the end of the day, there was less effective competition. That’s the bottom line.” DuPont says the combination of higher rates and increased fees puts it at a disadvantage to foreign importers, which can cherry-pick ports with access to multiple railroads. [Emphasis added]

These very special protections insulate the freight railroads from the recent upsurge in antitrust enforcement from the Obama administration, and this of course redounds to the benefit of those who own the freight railroads.

The STB plays an absolutely crucial role, and influencing the composition and the mandate of the STB is crucial to maintaining the freight industry’s special protections: 

In most industries rising profits are cause for celebration. In the railroad business they are a touchstone for controversy. The Senate Commerce Committee issued a report last year that flayed the industry for excessive profits. (That committee is headed by Jay Rockefeller [D-W.Va.], ironically, the great-grandson of the monopolist John D.) A recent Citigroup report noted that railroad profitability has increased 121% since 2004, “despite the industry actually moving less volumes.” Shares of Union Pacific, Norfolk Southern, and CSX have returned a cumulative average of 439% since 2000, vs. the S&P 500′s 9% return. BNSF has generated sizable rewards for Berkshire, and is expected to boost the company’s pretax earnings power by 40% in a typical year.

Yet much to shippers’ frustration, the STB still posits in its annual “revenue adequacy” report that none of the railroads are earning sufficient returns to necessitate greater regulation. The Rockefeller report panned the STB’s determination, asserting that “these claims need to be more carefully scrutinized.”

As Kimes goes on to note, shippers are hoping that the STB will change course and that it will take more aggressive action against the freight railroads, which have been accused of engaging in illegal price-fixing. I have no idea if it will happen or not. What I can say is that at least one influential American investor will not use his considerable political influence to bear on behalf of shippers. 

I should stress that I am tentatively somewhat more sympathetic to the freight railroads than to shippers, in part because I find the arguments raised by Union Pacific CEO Jim Young fairly convincing. Kimes, to her credit, gives her readers the freedom to draw their own conclusions, and she gives due regard to the strongest arguments of both sides. 

But I nevertheless wonder if Buffett’s admirers are aware of his keen, longstanding interest in cornering the market on cornering the market. Buffett is not America’s Carlos Slim. Fortunately, there is no American with Carlos Slim’s influence. But when the president of the United States name-checks a billionaire investor, when he seems to suggest that the fact that Warren Buffett and “the vast majority of wealthy Americans and CEOs” think that personal income taxes should raised on high earners has any relevance whatsoever, it gives me pause. 



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