This is many times worse than a high debt to equity ratio - The 5 Minute WrapUp by Equitymaster
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This is many times worse than a high debt to equity ratio

Nov 18, 2014

In this issue:
» What do higher truck sales indicate?
» Alarm bells ringing for the global economy...
» What falling Brent prices mean for India
» Indian start-up stories have come of age
» ...and more!

In 2009, the legendary investor Warren Buffett invested US$ 44 bn in the railway Burlington Northern Santa Fe (BNSF). At the time, he attracted some criticism for this investment. One was that the prospects of railways are largely dependent on how the energy story pans out. The other was the railway business typically incurs massive costs.

For instance, BNSF stated that in 2013 it made a record US$ 4 bn in capital investments. In 2014, it was looking to invest another US$ 5 bn. Around the time that Buffet acquired it, BNSF had a reasonably high debt equity ratio at 0.8 times.

Now quite some years back, Buffett had stated in one of his letters to shareholders that he would rather invest in businesses that report steady growth in earnings with little or no capital investments. Keeping all this in mind, does his investment in BNSF make sense?

Yes, it does if one looks at his rationale more closely. What makes the BNSF stock attractive today is that transport companies depend on oil, and crude prices in recent times have seen a sharp fall.

But that is not the reason why Buffett invested in the company. As he highlighted in his 2010 letter to shareholders, Buffett was of the view that railroads have major cost and environmental advantages over trucking, which is their main competitor. It is also more fuel efficient than trucking is. As Buffett noted, BNSF moved each ton of freight it carried a record 500 miles on a single gallon of diesel fuel. That is not all, Buffett also stated that more than 11% of all inter-city ton-miles of freight in the US is transported by BNSF.

Obviously, significant cost efficiency and its standing in the railroad industry meant that BNSF enjoyed considerable pricing power.

The point of this discussion is that most transport or utility companies will have the need for huge capital investments and will have to take on some debt to that extent. But that does not mean that one should shy away from investing in such businesses. For starters, most of them have a stable business model and have the ability to earn at least their cost of capital. Thus, the downside to that extent becomes limited.

The crux here then is the strength of the business model. Buffett may not have necessarily paid a bargain for BNSF. And as we have mentioned above, the debt equity ratio for the company is not really low. But what he has invested in is a stable business model with good pricing power. This becomes important because even if you invest in a company that has low debt, it could be one with a not so great business model. Thus, when things turn bad, such businesses are forced to resort to more debt just to stay in the business. And if the downturn lasts longer, the company could keep making very poor profits or even a loss maybe. In a way, it becomes a vicious circle with lower profitability leading to still higher debt which in turn leads to still lower profitability.

Do you think that investing in companies with good pricing power make attractive investment bets? Let us know your comments or share your views in the Equitymaster Club.

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As we have seen, falling crude prices is one reason to be positive about firms with high capex needs. However, there are other reasons to cheer the fall. Brent crude prices have fallen below US$ 79 per barrel. This has certainly helped to contain the current account deficit (CAD). The government has seized the opportunity to de-regulate diesel prices. With a lower payout for petroleum subsidies, the ambitious fiscal deficit targets too can be achieved.

It is sometimes forgotten that from a macro point of view, a falling fiscal deficit has a moderating impact on inflation. This will be music to the ears of the Reserve Bank of India (RBI). A steadily falling inflation rate creates an incentive for the central bank to cut interest rates. Falling interest rates in turn, provide a boost to economic activity. This is the link between falling crude prices and economic growth that markets understand so well. Thus it is not surprising that we have been seeing higher Sensex levels. However, as we have highlighted, investors should not jump into any stock. There is no substitute for disciplined stock picking we believe.

Crude prices may be falling down, but is it having any major impact on global growth? Alas, not really! To begin with, Japan has fallen into recession. Obviously, the PM Shinzo Abe's radical policies that included a heavy dose of stimulus have not worked. As reported on Moneynews, the economy contracted at an annual pace of 1.6% in the third quarter after housing and business investment dropped following a sales tax increase.

That is not all. Growth in China has slowed from 10.4% in 2010 to an estimated 7.5% this year. The Chinese government, in the meanwhile, is looking to bolster domestic spending and is also aiming to ease investments. China, so far, has been an exports driven economy and the slowdown in the West hasn't really helped matters. Things are not looking too great in Eurozone either as most economies struggle to recover. Whether the US is also recovering remains a big question. Because the US Fed would be reluctant to raise interest rates if it is of the view that the US economy is not yet on the mend. So far it has been quite vague about its intention to raise rates.

Indeed, the leaders of the world's 20 most developed economies have tried to boost confidence by promising to increase global output by US$ 2 trillion over the next five years. So far, the scenario does not look very encouraging.

 Chart of the day
Global growth may be tepid, but what can one say about the Indian economy? If one were to go by the data of heavy commercial vehicles (HCVs), there seems to be a gradual recovery in the economy. HCVs typically comprise trucks and buses and the fortunes of these are closely linked with that of the economy. As can be seen from the chart, FY13 and FY14 were terrible years for the HCV industry as volumes slumped drastically. But the last 5 months of FY15 has seen considerable improvement in volumes. This has been a product of low base effect as well as the economy gradually picking up. However, one will have to wait for a few more quarters, before a full recovery takes place.

Do higher truck sales signal economic recovery?

Here is another reason to be positive about the Indian economy. We have stated before that Indian corporates are still in wait and watch mode when it comes to making investments. However, there is one section of business that is thriving. We are referring to start-ups. Buoyed by venture capital (VC) funding, India's start-up stories seem to have come of age this year. Lured by the success of firms like Flipkart and Snapdeal, about half a dozen VC funds have raised over US$ 1 bn this year. This is more than triple of last year's figure of US$ 309 m. The good days seem to have just begun. There is an increasing confidence among global investors to bet big money on this entrepreneurial wave.

However, there is a flip side to this story as well. Sky high valuations are being accorded to these firms. Most of these start-ups are not profitable yet. Investors should be aware that many of these fast growing firms will look to list on the exchanges soon or later. At that time, the VC investors will look to exit. If the fundamentals do not justify the valuations at the time of the IPO, then investors will do well to avoid them.

The Indian stock markets had a rather volatile trading session today. At the time of writing, the BSE Sensex was trading up by around 5 points, while the NSE-Nifty was down 4 points. Gains were largely seen in auto and metals stocks, while IT and FMCG stocks were at the receiving end. Asian stock markets were trading mixed. While China and Hong Kong were out of favour, Japan and Indonesia were trading firm. European markets have, however, opened the day in the green.

 Today's investing mantra
"In this business, if you're good, you're right six times out of ten. You're never going to be right nine times out of ten". - Peter Lynch

This edition of The 5 Minute WrapUp is authored by Radhika Pandit.

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3 Responses to "This is many times worse than a high debt to equity ratio"

AB Pereira

Nov 19, 2014

You have stated BNSF had a high debt equity ratio of 0.8. Is there a typo? Else, from when did we start finding a D/E ratio below 1 to be high? For highly capital intensive projects (such as Railways), one thought of a D/E of 3-4 times Equity as bankable. Maybe I am too outdated to current norms.


AB Pereira

Nov 19, 2014

This refers to your 28 second story on the VC boom. For me, looking at the names of investees listed there, I get the 2000 dotcom bust to memory. Where else on earth can one find equity capital being brought in to splurge on trade discounts just to capture the market? And the market? Despite a scope to add volumes, the retail market offers very thin margins, especially in such competitive times! Good Lord!



Nov 18, 2014

Informations were interesting.People reading news paper regularly are aware of this info.

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