Monthly Archives: November 2009

Valuefocus (Issue 7) to be Released Tuesday

The latest issue of Valuefocus, our monthly Value Investing Newsletter will be sent to Premium Members on Tuesday December 1st. To become a premium member, visit HERE.


Dubai debt woes may hit U.S. property market

By Elinor Comlay and Jonathan Stempel (Reuters)

Dubai’s debt woes could further unhinge an already fragile U.S. commercial real estate, as it illustrates the importance of that tiny country to global investors in an increasingly interconnected world.

A state-owned investment conglomerate Dubai World, with $59 billion of liabilities, set off a global stock market selloff this week after it said it wants to restructure its debt, including at its property subsidiary Nakheel.

“This downturn has had more of a global impact,” said Tony Ciochetti, chairman of Massachusetts Institute of Technology’s Center for Real Estate in Cambridge, Massachusetts.

“As I try to explain to my students, with a global economy, we’re all attached at the hip financially in some way, shape or form,” he added.

The Dubai news also cast doubt over the strength of the fledgling U.S. economic recovery, and the prospects for a bottoming of property prices.

On Friday alone, the Dow Jones U.S. Real Estate Index (DJUSRE) fell 2.9 percent, nearly twice the decline of broader U.S. market indexes.

“Dubai may have to unload some very prestigious properties at distressed prices and this will drive the price of all commercial real estate lower,” wrote Richard Bove, a banking analyst at Rochdale Securities in Lutz, Florida.


In the United States, Dubai World’s portfolio includes several well-known properties, and the fallout could have a larger impact on the entire real estate market.

The company is a partner with casino operator MGM Mirage  in the $8.5 billion CityCenter project, which would add 6,000 rooms to a Las Vegas Strip gambling corridor already saturated with unoccupied hotel rooms.

Nakheel, perhaps best known as the developer of Dubai’s palm-shaped islands, also carries the Mandarin Oriental and W hotels in New York in its portfolio, and has a 50 percent stake in the Fontainebleau Miami Beach resort.

And, through its Istithmar affiliate, Dubai World controls the upscale retailer Barneys New York Inc.

The main threat to U.S. commercial property from Dubai World woes may be “potential for contagion,” said Sam Chandan, chief economist at Real Estate Econometrics LLC in New York.

“It has the potential to spill over into the broader perception of real estate development and real estate as being a very risky area for exposure,” Chandan said.

U.S. commercial real estate values have already fallen 42.9 percent from their 2007 peak, Moody’s Investors Service said.

Last month, delinquencies on U.S. commercial real estate loans that were packaged into commercial mortgage-backed securities reached 4.8 percent, more than six times the year earlier level, according to Trepp LLC in New York.

In a November 23 report, Moody’s analyst Nick Levidy said prices could bottom at 45 percent to 55 percent below their peak, implying an additional 5 percent to 28 percent decline, but in a “stress case” could drop 65 percent from their peak.


Like U.S. investors, foreign investors were enticed through much of this decade to buy U.S. real estate aided by cheap credit and the hope that property prices would steadily rise for a long time.

Currency fluctuations also provided a boost.

And the U.S. dollar lost about one-third of its value against a basket of currencies .DXY since late 2002, making it easier for foreign investors to scoop up U.S. real estate even when valuations grew too rich for investors at home.

Dubai World’s holdings go far beyond real estate. It has a 20 percent stake in Canada’s Cirque du Soleil, and also invests in the global bank Standard Chartered Plc  and New York boutique investment bank Perella Weinberg Partners.

Other investments go farther afield — or under water. Dubai World is suing a former executive in a case arising from a wayward foray into submarine financing.

But Ciochetti suggested it is premature to quantify Dubai World’s impact on U.S. commercial real estate.

“It is hard to focus on any one particular participant and then generalize about the whole market,” he said. “It illustrates that very few places and participants in the commercial real estate market are totally exempt from the global economic crisis.”

Dubai Jitters Infect Debt of Sovereign Spendthrifts

by Neil Shah and Chip Cummins (WSJ)

Dubai’s debt debacle is stoking a new fear for investors across the globe: potential government default by heavily indebted nations.

The Dubai government roiled markets this week with its move to delay debt payments owed by its flagship holding company, Dubai World. The company is stressed by tens of billions in debt that funded spending on glitzy real-estate projects from the Middle East to Las Vegas.

On Friday, investors feared Dubai’s move would plunge global financial markets into the kind of chaos seen earlier this year. But while Asia suffered heavy losses, markets regained their poise as the European and U.S. trading day progressed. By late Friday, European stocks finished 1.2% higher, while in the U.S., the Dow Jones Industrial Average closed down 154.48 points, or 1.5%, at 10309.92.

Deeper stress lines were felt in the sovereign-bond market, where the cost of insuring against defaults in places like Hungary, Turkey, Bulgaria, Brazil, Mexico and Russia rose, fueled by concerns that emerging-market nations may have trouble honoring their debts even as the economy heals. The worry is that sovereign debt may now represent another aftershock of the global financial crisis.

Dubai’s debt debacle is stoking a new fear for investors across the globe: potential government default by heavily indebted nations.

The Dubai government roiled markets this week with its move to delay debt payments owed by its flagship holding company, Dubai World. The company is stressed by tens of billions in debt that funded spending on glitzy real-estate projects from the Middle East to Las Vegas.

On Friday, investors feared Dubai’s move would plunge global financial markets into the kind of chaos seen earlier this year. But while Asia suffered heavy losses, markets regained their poise as the European and U.S. trading day progressed. By late Friday, European stocks finished 1.2% higher, while in the U.S., the Dow Jones Industrial Average closed down 154.48 points, or 1.5%, at 10309.92.

Deeper stress lines were felt in the sovereign-bond market, where the cost of insuring against defaults in places like Hungary, Turkey, Bulgaria, Brazil, Mexico and Russia rose, fueled by concerns that emerging-market nations may have trouble honoring their debts even as the economy heals. The worry is that sovereign debt may now represent another aftershock of the global financial crisis.

“First, people were worried about mortgage debtors. Then, highly leveraged banks. Now the ball has rolled all the way to Dubai,” says Mattias Westman, chief executive of Prosperity Capital Management, which has about $3.5 billion under management, almost all of it in Russia. “It’s just a lack of confidence in debtors.”

The price of a $3.5 billion sukuk, or Islamic bond, issued by a subsidiary of Dubai World, plunged to 57 cents on the dollar Friday from 110 cents on Wednesday, according to two investors.

Dubai’s troubles resonate far beyond the desert fantasyland that its borrowing created, fueling concerns that financially stretched nations like Greece and Hungary may struggle to pay off debts.

Investors and analysts say they’re worried about the health of Greece’s heavily indebted economy and banks, which could suffer as the European Central Bank moves to pull away some of its financial-support measures. These measures have included ultra-cheap bank funding.

The gap between the yield on a Greek government bond and relatively-safe German debt — a key gauge of market fear — jumped to a peak of 2.2% Friday, before falling slightly. When the pan-European Stoxx 600 index fell 3.3% on Thursday, Greece’s market fell twice that amount, over 6%.

Another window into the growing concern about government creditworthiness is the credit-derivatives market. Investors are now paying much higher prices to insure themselves against bond defaults in countries like Turkey and Bulgaria.

When Dubai announced its debt standstill on Wednesday, the cost of insuring against a Dubai debt default more than doubled. The cost of debt-default insurance also rose for a range of countries, including Hungary, Brazil, Mexico and Russia.

While the cost of debt insurance for stressed countries hasn’t hit levels seen at the height of the financial crisis, “the recent rises are altogether more sinister in our view, as they reflect genuine concerns about default within the euro-zone,” said Steven Barrow, a currency analyst at Standard Bank in London, in a note Friday.

Dubai itself demonstrates how quickly countries can veer off the road to recovery and into trouble.

Dubai’s surprise move to delay the debt payments of its corporate crown jewel, Dubai World, came just as many economic indicators, and anecdotal evidence, were pointing in a positive direction. Among the optimistic signs for the region: Oil prices have rebounded strongly this year after falling sharply during the global financial crisis. On Friday, oil sank 2.5% to $76.05 a barrel on the New York Mercantile Exchange as investors fretted over the impact of the Dubai debacle on the economic recovery, but that’s still up significantly from its lows earlier this year.

At the same time, though, years of lavish, debt-fueled empire building is now coming home to roost. For years, the city-state was the epicenter of a dizzying boom in the Persian Gulf. Its ambitions also extended abroad: to golf courses in Scotland and South Africa; the Barneys department store chain in New York; and real estate in Las Vegas, where in 2007 it joined up with casino company MGM Mirage to develop an $8.5 billion condo, hotel and retail colossus called CityCenter — just as the Vegas real-estate market reached its peak.

The oil-fired investment and spending binge culminated in 2008 when crude hit more than $140 a barrel. But by the time of Dubai’s biggest bash later that year — a $20-million hotel opening on a man-made palm-shaped island developed by Dubai World’s property subsidiary — the global financial crisis was already washing ashore.

Since then, it has been a steady slide toward Wednesday’s debt standstill. Squeezed by frozen credit, international property speculators bowed out of Dubai’s market. Prices started a year-long, steep descent. Government-controlled and private developers postponed or cancelled projects, shed workers and stopped paying bills.

According to the Association for Consultancy and Engineering, a trade group of British builders, Dubai entities owe as much as £200 million to British contractors alone.

Analysts expect Dubai’s core property market to take years to claw back to 2008 levels.

Even after hundreds of projects were cancelled or postponed this year, new construction is expected to double Dubai’s supply of office space by 2011, according to property consultancy Colliers International. In a sample study, the consultancy found office-occupancy rates in recently finished buildings at just 41%. At the end of the third quarter, prices of office space were down by 58% from a year ago.

Still, international bankers and executives had started pointing to anecdotal evidence of recovery before the standstill announcement. “You see ‘for rent’ signs on every building,” says Ziad Makhzoumi, chief financial officer of Arabtec Holding PJSC, one of the Mideast’s biggest construction companies. “But you don’t see them on every floor.”

Investment firm Chieftain Capital to split over Internal Rifts

By Shira Ovide & Gregory Zuckerman (WSJ)

Chieftain Capital Management Inc., an iconoclastic investment firm with a strong two-decade track record, is splitting up following personality conflicts among its leaders, according to people familiar with the matter.

Co-founder Glenn Greenberg, who came into the headlines nearly two years ago for his campaign against management at cable company Comcast Corp., plans to stay at the firm, according to a letter that he, co-founder John Shapiro and two partners sent to investors. Mr. Greenberg’s firm will be renamed Brave Warrior Advisors, according to a person familiar with the matter.

Mr. Shapiro and Chieftain partners Tom Stern and Joshua Slocum plan to launch a new investment firm that will retain the name Chieftain Capital Management, effective Jan. 1, according to the letter. Chieftain manages about $3 billion in assets. Messrs. Shapiro and Stern are cousins.

“Although Chieftain’s partners remain committed to the firm’s investment philosophy, differences on internal firm matters have led us to decide to separate,” said the letter, sent to investors earlier this month.

Mr. Greenberg, son of legendary baseball player Hank Greenberg and a former competitive squash player, founded Chieftain with Mr. Shapiro in 1984.

A person familiar with what Mr. Greenberg has told investors said Mr. Greenberg and Mr. Stern had personality conflicts, and Mr. Shapiro decided to leave with Mr. Stern. Another person said the personality conflicts were between Mr. Greenberg and the three other officials who are starting the new firm.

Through spokesmen, Messrs. Greenberg, Shapiro, Stern and Slocum declined to comment.

At one point, the firm considered retaining an executive-conflict-resolution specialist, according to people familiar with the matter, though it is unclear if it retained one.

The firm has generated annual gains averaging about 18% before fees focusing on “value” investing, or buying inexpensive, sometimes out-of-favor shares in which the firm has deep conviction. Chieftain’s returns are roughly in line with the market so far this year, according to people familiar with the matter. The firm counts among its clients Yale University’s endowment.

While many other investment managers spend much of their time courting new and existing clients, Mr. Greenberg told Wharton School students several years ago that his firm was built on keeping his communications with clients limited, ignoring ideas from Wall Street analysts and avoiding the marketing of his firm.

The firm disdained Wall Street’s mantra of diversification. Chieftain’s largest stock holdings as of Sept. 30 included Lockheed Martin Corp., U.S. Bancorp, and Comcast, three stocks that represented more than 40% of Chieftain’s stock holdings, according to FactSet Research Systems. By contrast, some funds often keep their top positions at less than 5% of their holdings.

Going against the firm’s typically quiet style, Mr. Greenberg in early 2008 launched a public campaign against Comcast management. He sought in part the ouster of Chief Executive Brian Roberts over complaints about the cable company’s strategy and uses of capital.

Comcast at the time said the company’s operating record, growth and stock returns were strong.

After Mr. Greenberg’s campaign went public, Comcast changed some compensation policies and started a dividend, and the Chieftain campaign died down. Mr. Roberts remains Comcast’s chairman and CEO.

More recently, Mr. Greenberg had been noncommittal about Comcast’s negotiations to buy a controlling stake in General Electric Co.’s NBC Universal. He told the Journal last month that Comcast has moved in the “right direction” since his campaign last year, but he said he would reserve judgment on the possible NBC Universal deal.

After the firm’s planned breakup, Bryan R. Lawrence, the founder of Oakcliff Capital, will work with Mr. Greenberg, as will Mary Mulholland, Chieftain’s vice president of administration, the Chieftain officials said in the letter to investors.

The letter said clients will be asked to select which of the new firms will manage their investment assets.

Paul Fribourg, chairman and chief executive of agribusiness-and-investment firm Continental Grain Co., a longtime investor with Chieftain, said the firm was a collection of “smart, strong-willed, opinionated” people but “I don’t think there’s any hidden mystery or blowup.” Mr. Fribourg, who added that he had no direct knowledge of why the firm was splitting up, said he hadn’t yet decided what he’d do with his Chieftain investments.

Paulson Buys Banks That Lost Value in Credit Crisis

By Saijel Kishan and Cristina Alesci

Aug. 13 (Bloomberg) — John Paulson, the hedge-fund manager whose wagers against the U.S. housing market helped him earn an estimated $2.5 billion last year, bought Bank of America Corp. and Goldman Sachs Group Inc. stock in the second quarter, while adding to stakes in gold companies.

His firm, Paulson & Co., bought 168 million shares of Charlotte, North Carolina-based Bank of America valued at $2.2 billion as of June 30, according to a filing yesterday with the U.S. Securities and Exchange Commission. It was the biggest new purchase in the second quarter for Paulson, 53, and made him the bank’s fourth-largest owner.

“It’s ironic because he was the one that made the right call shorting subprime,” said Jerome Dodson, who oversees $2.5 billion at Parnassus Investments in San Francisco. “His timing is good but he probably won’t be as successful with this purchase as he was with betting the housing market would collapse.”

Paulson, who manages about $29 billion, last year started a hedge fund, called Paulson Recovery fund, to invest in financial firms hurt by mortgage writedowns. He boosted investments in gold companies this year to help mitigate potential inflation as governments worldwide increase spending to help their economies recover from recession. Gold has gained 7.7 percent this year.

Stefan Prelog, a spokesman for New York-based Paulson, declined to comment on the filing.

Bank Stocks

Bank of America gained 94 percent in the second quarter as concern the government would take an ownership stake eased amid signs of an improving economy. Paulson also bought 2 million shares of Goldman Sachs, the New York-based investment bank, in the period.

He ended the quarter with 7 percent of the UltraShort Financials ProShares exchange-traded fund, which is used by investors who expect bank shares to decline. The fund declined 57 percent in the quarter as the Dow Jones U.S. Financials Index rose 29 percent. Paulson’s 2 million shares were valued at $84 million on June 30.

Bank of America is the second-largest home lender, trailing Wells Fargo & Co., after acquiring Countrywide Financial Corp. last year. Countrywide lost $703.5 million in 2007 and almost collapsed under the weight of defaulting subprime mortgages.

Paulson’s filing came a day after Timothy Barakett, founder of the $5.5 billion Atticus Capital LP, said he was closing his $3.5 billion Atticus Global Fund to spend more time with his family and concentrate on philanthropic interests. Atticus bought Bank of America shares valued at $355 million in the second quarter, according to a regulatory filing on Aug. 10.

Betting on Gold

Paulson’s stake in the bank is the fund’s second-biggest holding after SPDR Gold Trust. He left unchanged his 9 percent stake in the investment fund that buys gold bullion, according to the filing.

His firm became the largest holder of Johannesburg-based gold producer AngloGold Ashanti Ltd. after buying 40 million shares to end the quarter with a 12 percent stake. Paulson also increased his stake in Johannesburg-based Gold Fields Ltd., becoming the third-largest owner of its U.S.-listed shares.

The fund reduced its stake in Market Vectors Gold Miners ETF, a fund that mirrors moves in the Amex Gold Miners Index, after selling 11 million shares. He owned a 5.3 percent stake in the fund in the second quarter valued at $227 million, down from 15 percent in the first three months of the year.

The hedge fund manager left unchanged a 4.4 percent stake in mining firm Kinross Gold Corp., according to the filing.

Paulson’s Pay

Paulson earned an estimated $2.5 billion last year, according to Institutional Investor’s Alpha Magazine. His Credit Opportunities Fund soared almost sixfold in 2007 on bets that subprime mortgages would plummet.

Last year, his largest fund, the Advantage Plus Fund, returned 37 percent, compared with a loss of 19 percent for hedge funds on average. The fund has gained 16 percent this year. The industry has returned 12 percent, according to Hedge Fund Research Inc.

Money managers who oversee more than $100 million in equities must file a Form 13F within 45 days of each quarter’s end to list their U.S.-traded stocks, options and convertible bonds. The filings don’t show non-U.S. securities or how much cash the firms hold.

Paulson reported holdings valued at $17.1 billion at the end of June compared with $9.3 billion at the end of the first quarter. He placed bets during the quarter on companies including Sun Microsystems Inc. and Wyeth that are takeover targets.

Tech, Drug Stocks

Paulson bought 74 million shares of Santa Clara, California-based Sun Microsystems, which is being taken over by Oracle Corp. for $7.4 billion. The new purchase was his second- largest in the second quarter, according to the filing.

The hedge fund increased its stake in Madison, New Jersey- based Wyeth, which is set to be acquired by Pfizer Inc., by buying 18 million shares of the drugmaker, according to the filing.

Paulson also increased his stake in Schering-Plough Corp. after buying 44 million shares in the Kenilworth, New Jersey- based firm. Schering-Plough agreed in March to be taken over by Merck & Co.

Mutual Funds’ Streak at 34

By John Kell (WSJ)

Long-term mutual funds saw net inflows for the 34th straight week as more money going to hybrid and bond funds again offset stock-fund outflows, according to figures released Wednesday by the Investment Company Institute.

Total estimated inflows were $3.14 billion in the week ended Nov. 4, putting the total during the streak at about $349 billion.

Stock funds had outflows of $4.7 billion, compared with outflows of $840 million last week. U.S. stock funds took out $5.25 billion, while foreign funds had $546 million added to them. The U.S. decline comes as the stock market continues to rally.

At the same time, bond funds had estimated inflows of $7.49 billion, down from $10.19 billion the previous week, according to the ICI. Taxable funds added $6.59 billion, while municipal ones put in $899 million.

Investors put $358 million into hybrid funds, compared with $239 million the previous week, the institute said. Such funds can invest in both stocks and fixed-income assets.

Meanwhile, assets in money-market funds declined $13.13 billion in the latest week, continuing a recent trend of outflows, this time due to steep government fund withdrawals, according to iMoneyNet.

Cash has been leaving money-market funds as investors have been seeking higher returns—yields for the funds have been close to zero for months. But some economists are predicting a Federal Reserve Board rate increase next year, which would be a welcome break for fund companies that have been waiving fees on their funds in order to maintain investors.

The seven-day yield on taxable money-market funds held steady for a third week at a record low of 0.04%. The yield has been steadily declining in the wake of a decision by the Federal Reserve to keep the target federal-fund rate under 0.25%, which it affirmed last week.

For the week ended Tuesday, total assets in money-market funds dropped to $3.3 trillion.

Overall, taxable funds fell $12.48 billion to $2.888 trillion as institutional investors took out $11.62 billion and individual investors withdrew $861.3 million. Prime funds, which invest in securities such as commercial paper, saw assets dropped $1.27 billion. Government funds had $11.21 billion in outflows, according to iMoneyNet.

Tax-free funds posted outflows of $649.8 million, as yields at seven-day funds dropped to 0.04% from 0.05% but held steady at 0.05% for 30-day funds.

VIC Submission: La Jolla Pharmaceutical (LJPC)

Submitted: October 5, 2009

Accepted: November 1, 2009


I have encountered a great shorting opportunity within the nanocap universe with La Jolla Pharmaceutical (LJPC). LJPC is a biopharmaceutical company that engages in the discovery and development of orally-active small molecules for the treatment of autoimmune diseases, and acute and chronic inflammatory disorders. Because the company is currently trading at 5X net cash value ($0.22/share) and it is in the process of liquidating, this is a great shorting opportunity.


In February 2009, the company was informed by an Independent Monitoring Board for the monitoring board that continuing the study of the Riquent drug was futile. LJPC had previously devoted substantially all of its research, development and clinical efforts and financial resources toward the development of Riquent.

In July 2009, LJPC announced that, in light of other alternatives, a wind down of the business would be in the best interests of stockholders.


The Company has no other drugs in the pipeline, and has scheduled a stockholders meeting for october 31, 2009. The board expects the shareholders will approve the liquidation of the business at the stated date. Below is an estimate of the liquidation value of the company, not including the expenses to be incurred in the process of liquidation.

Cash and cash equivalents                              $8,509 (as of June 2009)
Total Liabilities                                                    $3,836
Off-Balance Sheet Obligations                        $0
Net Cash Value                                                     $4,673

Est. Additional Operational Expenses       $2,096 (through October 2009)
Adj. Net Cash Value                                           $2577

Adj. Net Cash Value per Share                      $0.04

I estimate the company’s liquidating value to be at $0.04/share at best, compared to the company’s market value of $0.20/share. Because expenses will have to be incurred to liquidate the business, we expect the actual cash distribution to shareholders to be below the estimated $0.04/share.

In a DEF14 form filed with the SEC on October 1, 2009 the company provided its estimates of stockholder distributions. The company’s management estimated that distributions will range from $0.028/share to $0.045/share, significantly below the current market value of $0.20/share.


Several reasons why I believe the company’s liquidation is certain:

- For over 6 months, LJPC explored strategic alternatives, including undertaking efforts to identify a merger, reverse merger, stock or asset sale, strategic partnership or other business combination transaction that would have a reasonable likelihood of providing greater value to our stockholders than they would receive in a liquidation, which did not result in the identification of any likely transaction.

- The board believes that there is a low probability that LJPC would be presented with, or otherwise identify, within a reasonable period of time under current circumstances, any viable opportunities to engage in an attractive alternative business combination or other strategic transaction that would provide enhanced value to stockholders.

- LJPC has only three full-time employees remaining, two of which make up the management team consisting of a President and Chief Executive Officer and a Vice President of Finance and Secretary.


The biggest risk is the possibility of a merger or buyout above the current market value. This is unlikely, as the company has no patents nor other intellectual property that would encourage potential buyers to pay a value above LJPC’s net cash. The 5X premium to net cash value in unwarranted, as the likelihood of liquidation is high. This presents a great shorting opportunity for investors.


In July 2009, LJPC announced that, in light of other alternatives, a wind down of the business would be in the best interests of stockholders.



ValueHuntr accepted to Value Investors Club (VIC)

We have just been accepted into the Value Investors Club (VIC),  an exclusive community of about 200 value-oriented investors.

Anyone can get guest access with a 45-day read-only delay, but only members get to exchange views in real-time, both in the form of idea write-ups and message board discussion. 

The outperformance of stocks recommended by members have made memberships a coveted commodity, and acceptance rate is extremely low. We are proud of the recognition and we look forward to contribute to both VIC and Valuehuntr Blog in the future.

Behind Buffett’s Decision, a Lesson From a Mentor

By Jason Zweig (WSJ)

Warren Buffett’s purchase of Burlington Northern Santa Fe Corp. (BNI) is the newest chapter in the oldest story of his professional life.

Mr. Buffett’s mentor, the pioneering “value” investor Benjamin Graham, trafficked for decades in railroad stocks and bonds. In the early 1950s, at the outset of his career, Mr. Buffett read every page in Moody’s voluminous transportation manuals — twice, to make sure he didn’t miss anything. Working at Mr. Graham’s fund, Graham-Newman Corp., Mr. Buffett analyzed a portfolio with 21% to 36% of its assets in railroads.

But there is a more subtle side to the story. Mr. 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.

Graham also highlighted a painful paradox: The better the business and the more skilled its managers, the greater its profits, causing cash to pile up to unreasonable levels. And, to Mr. Buffett’s own chronic discomfort, he and Berkshire Hathaway are living proof of Mr. Graham’s paradox. 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.

As long ago as 1998 — when Berkshire had $122 billion in assets and less than $14 billion in cash — Mr. Buffett worried his company was getting too big for its britches. “We have always known,” he wrote to a fellow investor, “that huge increases in managed funds would dramatically diminish our universe of investment choices.” That’s because investments of a few million dollars apiece could no longer make a material difference to Berkshire’s fortunes.

By 2006, when Berkshire’s cash mountain had risen to $37 billion, Mr. Buffett said, “We don’t like excess cash…We would be much happier if we had $10 billion.”

“Size is always a problem,” Mr. Buffett told me last month. “With tiny sums [to invest], it’s extraordinary what you can find. Most of the time, big sums are one hell of an anchor.”

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.

Mr. Buffett is paying for Burlington Northern partly with Berkshire shares — something he has long been loath to do. In 2007 he lamented buying Dexter Shoe in 1993 for $433 million in Berkshire stock — which would later have been worth at least $3.5 billion if Mr. Buffett had not exchanged them for Dexter, which ended up worthless. “He’s so sensitive to this issue that I can’t believe he would [pay in stock for Burlington Northern] unless he had absolute confidence that it will work out well over time,” says David Carr of Oak Value Fund, which owns $25 million in Berkshire shares.

At age 79, Mr. Buffett has no plans to retire, but he wants to ensure that Berkshire’s businesses will endure for decades after he is gone. He is betting that no new technology can make rail transportation obsolete. Mr. Buffett has sometimes been wrong about which businesses will prosper forever. Over the years, he’s invested in shoes, newspapers and printed encyclopedias. But Mr. Buffett’s approach underscores a key lesson for any investor: Before you buy any business, ask how vulnerable it is to new technology or price competition.

As a result of the Burlington Northern deal, Berkshire’s Class B shares will split 50-for-1, which would knock its share price down from $3,300 to $65. That puts the shares, for the first time in years, within psychological reach of most investors (who have long balked at Berkshire’s high per-share price).

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.

Buffett to Acquire Burlington Northern


Berkshire Hathaway Inc. agreed to acquire the 77% of Burlington Northern Santa Fe Corp. it doesn’t already own for about $26 billion in cash and stock, placing a hefty wager on the economic recovery. The deal values all of the railroad holding company at $34 billion. Berkshire Chairman and Chief Executive Warren Buffett called the deal, Berkshire’s biggest ever, “a huge bet and one that I’m very happy to make, but it’s not a bet on next month or next year. We’re going to own it forever.”

The $100 a share he offered was “all I could pay,” he said in an interview, structuring the deal as 60% in cash and the rest in stock because “we couldn’t do an all-cash deal.” Mr. Buffett said he was loath to part with Berkshire shares but that doing so was “necessary to get the deal done.” After the purchase, Berkshire will have $20 billion in cash, he said. Berkshire, Omaha, Neb., also will assume $10 billion of Burlington Northern debt.

Matthew K. Rose, Burlington Northern’s chairman, CEO and president, said the deal took about 10 days to work out, from Berkshire’s offer to the railroad’s board meeting Monday night. Mr. Buffett “knows exactly what he wants and he’s pretty fair,” Mr. Rose told Fox Business News.

Mr. Buffett’s move appears to be a bet that the freight industry is poised for recovery, though it hasn’t shown much of a rebound yet. The best that most rail executives have said about volume is that it seems to have hit bottom. Burlington and other top railroads are considered a barometer of economic activity because of the breadth of goods they carry, and Mr. Buffett has said he uses weekly railroad data as a proxy for the economy’s health.

The acquisition also exemplifies Mr. Buffett’s taste for solidly profitable companies that aren’t dependent on cutting-edge technology. Burlington Northern, Fort Worth, Texas, is viewed as one of the best-managed U.S. railroads, though recently it has underperformed its rivals and last month it cut its fourth-quarter forecast. Burlington Northern reported that third-quarter profit fell a less-than-expected 30% as revenue and volume fell across the board.

The company has 32,000 miles of track in 28 states and Canada, and its $18.02 billion in sales last year made it just barely the No. 1 rail company in the U.S., ahead of Union Pacific Corp.

The purchase would help secure a supply chain for Berkshire’s rapidly expanding energy businesses. Berkshire owns MidAmerican Energy Holding Co., which operates a natural-gas pipeline and power companies in the Midwest and Northwest. Burlington tracks run through the regions, a coal-supply route for power plants.

Mr. Buffett said Burlington Northern was a similar business to MidAmerican. “I would use the word solid,” Mr. Buffett said. “There’s nobody better at running a railroad than Matt Rose.” Mr. Buffett said that the railroad’s management team is part of what made the deal attractive.

The $100 a share Berkshire is paying is a 31% premium to the railroad’s closing price Monday. Burlington Northern’s shares were up about 28% Tuesday afternoon. Berkshire’s Class A shares rose slightly.

Berkshire stuck the deal with Burlington Northern’s stock trading about 50% higher than its March lows. “You do what you can when you can,” Mr. Buffett explained.

“It doesn’t look like he got this on the cheap,” said Catherine Seifert, an analyst with Standard & Poor’s. She said the deal could change Berkshire’s profile from that of an insurance-based conglomerate heavy on financial services to more of an industrial company. “What is this telling us about his feeling about investing in financial services when his big bet is outside financial services?”

The deal comes after a five-year rail renaissance that saw volume and pricing soar. That ended as the recession cut deeply into traffic and profits. Railroad operators have used the slump to boost efficiency, but future investment hinges on a slew of tax credits and other measures being pushed by industry executives in Congress.

Longbow Research analyst Lee Klaskow said Burlington Northern has “fantastic franchises” in coal and agricultural products that will rebound once the economy turns a corner. “In the long term, it will probably be a great deal for Berkshire Hathaway.”

Under the deal, Burlington Northern stockholders will have the choice to exchange each share for either $100 in cash or Berkshire stock. Mr. Buffett said a decision announced Tuesday to split Berkshire’s Class B shares on a 50-1 basis was meant to create a tax-free deal for Burlington Northern shareholders, some of whom might not have had enough stock to exchange for a Class B share of Berkshire Hathaway, which traded at $3,326 Monday.

The acquisition, which has been approved by the boards of both companies, is subject to approval by regulators and Burlington Northern shareholders. The companies expect the transaction to close in the first quarter.