We start with the Big Five Numbers and Debt 1 Return on Invested Capital 2

We start with the big five numbers and debt 1 return

This preview shows page 104 - 107 out of 263 pages.

We start with the Big Five Numbers and Debt: (1) Return on Invested Capital , (2) Sales Growth Rate , (3) Earnings Growth Rate , (4) Equity Growth Rate , (5) Cash Growth Rate, and Debt . We want all of these growth rates to be 10 percent or better for many years in the past. The most important number is the Return on Invested Capital (ROC or ROIC). This tells us how the company is doing at investing the money it’s getting from investors and from borrowing. And in looking at BNI’s Investment Returns, we get an immediate red flag: Check out the five-year average Return On Capital: 5.1 percent. What in the world is Warren Buffett doing buying a business with a 5 percent Return on Capital? Simple answer: He’s buying it because he believes the Return on Capital is going up and will probably be going up more in the future. According to the annual report, Burlington poured $24 billion into new track and equipment to prepare for a doubling of
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freight tonnage in the next two decades. If management is right about the demand for rail freight, and obviously Warren Buffett thinks it is, then it’s likely that investment in infrastructure will result in an increase in ROC over time. A secondary indication of which way ROIC will go is Return on Equity (ROE). Think of ROE as Return on Capital’s younger brother. Same family, but ROE isn’t quite as grown up as ROC. ROE is calculated without considering borrowed money. When you remove debt from the equation, then the managers suddenly look like better managers: 14 percent average for five years and 18 percent last year. Those are good numbers. That fact means there might be more to the low ROC than meets the eye. In the 10 years that ended in 2007, BNSF spent nearly $24 billion to improve our infrastructure. That includes maintaining a strong infrastructure through strategic investments in expanded track, yards and terminals; track renewal: technology; and acquiring more than 2,700 new, high-efficiency locomotives. All of our investments in infrastructure, equipment, asset utilization, people and technology help ensure we have the capacity to meet current and future freight transportation needs, while also improving our operating reliability and efficiency, From BNI’s 2007 annual report and Form 10-K There is one time when it’s fair to buy a business with low ROC: if whatever they spent the borrowed money on is about to produce a good ROC. For example, if Burlington borrowed the money to build a new line from L.A. to Chicago so they could double the amount of stuff they could move from the ports in L.A. to shippers in Chicago, the borrowed money
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would produce no return until the track was completed. That construction might take years, and during all that time the debt is calculated as part of the ROIC calculation without any corresponding return at all. It looks bad for the managers, but only if you don’t know your business. If you understand Burlington—and if you know enough about the business to agree with their prediction about freight demand— you would expect the ROIC to go up.
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  • Spring '20
  • Warren Buffett

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