Here's How Buffett Beats the Market - TheStreet

Increasingly worried that the Dow Jones Industrial Average is too expensive after reaching a record closing high of 12,961 on April 20? Sitting on cash waiting for the market to correct and yet fearful that the rally will leave you behind?

Well, then, let legendary value investor Warren Buffett's recent purchase of 11% of railroad

Burlington Northern Santa Fe

( BNI) -- worth about $3 billion -- remind you that there is another way to think about the stock market that doesn't involve attempts to predict market tops or bottoms.

The key to Buffett's buy is a measure called return on invested capital, or ROIC, which indicates a company's power to grow its business profitably for investors over time. If a company's ROIC is high enough, it puts the massive power of compounding on the long-term investor's side. If return on invested capital isn't high enough, no share price is low enough to justify purchase by a long-term buy-and-hold investor.

The utility of Buffett's logic and the ROIC measure isn't limited to railroad stocks. It's especially well-suited to today's equity markets and increasingly global economy, and it's a great guide for picking stocks for your portfolio when the stock market indices are at historical highs.

Why Railroads and Why Now?

Of course, to apply Buffett's logic, you first have to understand exactly why Buffett bought shares of Burlington Northern and two other railroads

now

.

At first -- and even second -- glance, the timing seems odd even for Warren Buffett, who says he never tries to time the stock market. Even though Buffett bought his stake in Burlington Northern a few months ago, he was still loading up near an all-time high for the railroad's shares and near an all-time high for the Dow. To make things even more puzzling, he was buying as the U.S. economy seemed to be slowing. Railroads are notoriously

cyclical stock that do well when economic growth is speeding up and head rapidly downward when growth slows.

For example, Burlington Northern shares hit a high in April 1999 and bottomed in February 2000 as investors began to anticipate an economic slowdown. Real growth in the U.S. economy was a very robust 3.7% in 2000 and sank to a barely visible 0.1% in 2001.

It is not possible for me to believe that as experienced an investor as Buffett has forgotten the cyclical record of a railroad stock such as Burlington Northern. So what was he thinking as he pulled the trading trigger and put $3 billion into this cyclical stock at what looks like a market and economic peak?

In my opinion, he was thinking that, as he has so often reminded investors, he doesn't buy stocks -- he buys companies. And if you're buying a railroad company, this is exactly the right time.

Why? Because the company's return on invested capital has finally inched above its cost of capital.

For years, railroads, even such recently well-run railroads as Burlington Northern, have earned a lower return on the capital they invest in their business than that capital cost them in the marketplace. That's not a recipe for bankruptcy -- a company can chug along in this position for pretty much forever because, thanks to operating leverage, it doesn't have to invest a dollar of capital to produce a dollar in earnings.

But earning less than the market cost of your capital sure doesn't encourage reinvesting profits in your business: The return is so low that it's more attractive to pay dividends or buy back shares. And that eliminates the power of compounding from the company's growth. Sure, the company can throw off lots of cash, as railroads do, but since they aren't reinvesting that cash, the business and the cash flow aren't growing at a compounded rate every year.

Standard & Poor's puts the weighted average cost of capital for Burlington Northern at 8.5%. The company didn't make that on average over the past five years. The five-year average is just 4.5% for the company and the railroad industry.

Railroads' Rising Return

What the data don't show is that Burlington Northern and railroads in general haven't earned a return on invested capital above their cost of capital for considerably longer than five years. The last time these businesses were consistently that profitable was in the early years of the 20th century, roughly 90 years ago.

But that's been changing recently. Return on invested capital has climbed to 6.8% over the past 12 months. And in the past few months, return on invested capital has grown even more, so that it is either close to or actually exceeds the company's cost of capital.

Railroads as a whole are riding this trend. In the past few months,

Canadian National Railway

(CNI) - Get Report

and

Norfolk Southern

(NSC) - Get Report

have also recorded returns on invested capital near their costs of capital.

CSX Corp.

(CSX) - Get Report

and

Union Pacific

(UNP) - Get Report

seem likely to pass this mark in the next few quarters.

So Buffett bought into the railroad sector just at the point when railroads could put the power of compounding to work, reinvesting this year's earnings and earning a high enough return to justify investing the earnings on those reinvested earnings next year.

For a long-term investor such as Buffett, that turning point in a company's (and sector's) fortunes is more important than any temporary spike in the stock price -- because reinvesting and compounding each year's earnings grows the business at a rate that, in the long term, overwhelms any effect of buying at a temporary top.

This analysis -- and I readily concede it's only my reconstruction of what might be Buffett's thought processes -- would lead me to prefer Union Pacific to Burlington Northern. The latter railroad has raced ahead at the front of the ROIC pack because the company invested during the years when it was tough to justify investing in double-tracking, which allows trains going in opposite directions to pass each other more easily. The company now has far more of its routes double-tracked than a competitor such as Union Pacific. That makes Burlington Northern more efficient now, but it also means that Union Pacific has more future opportunity to reinvest capital playing catch-up.

You can extend this analysis not just across the railroad sector but across the entire global equity market. In the U.S. stock market, it explains why technology stocks such as

Motorola

( MOT),

Microsoft

(MSFT) - Get Report

and

Dell

(DELL) - Get Report

are struggling right now. They need to invest huge amounts of capital to stay competitive, but they face the potential for declining or at best steady returns on investment, thanks to that intense competition.

It also explains why stocks such as

PepsiCo

(PEP) - Get Report

and

McDonald's

(MCD) - Get Report

have done comparatively well. Both have shown the ability to sustain or increase returns on capital

and

have potentially huge opportunities to reinvest those returns profitably. Return on invested capital has climbed at PepsiCo to 24.9% in the past year from a five-year average of 20.5%. At McDonald's, the increase has been to 11.1% from a five-year average of 8.7%.

It also explains why some overseas stocks are so much more attractive to long-term investors than most U.S. equities. Which would you rather own for the long term: an established global information-technology company such as

IBM

(IBM) - Get Report

, which is fighting to hold on to market share and shows a return on invested capital of 14.3%, or a company with new markets to conquer as quickly as it can raise capital, such as

Infosys Technologies

(INFY) - Get Report

, with a return on invested capital of 37.4%? It's clear to me which company puts compound reinvesting to best use for the benefit of a long-term investor.

This concentration on return on invested capital certainly isn't the only way to make money in the stock market. But I bring this perspective up now at such length because Buffett's approach is a timely antidote to today's concentration on the latest earnings surprise and to worries about timing market tops. The issue for a stock such as

Yahoo!

(YHOO)

from this point of view isn't the penny miss on quarterly earnings announced recently but whether the company can reverse the decline of its return on invested capital to 6.4% in the past year from a five-year average of 11.1%.

And the question for a stock such as

Donaldson

(DCI) - Get Report

isn't whether the shares are setting up for a drop after setting all-time high after all-time high recently, especially considering the company's exposure to cyclical heavy-truck sales, but whether its new product efforts can keep ROIC near the recent 18.8%, up from the five-year average of 15.8%. That kind of jump in compounding potential is exactly what long-term investors should look for in this or any other market.

At the time of publication, Jim Jubak did not own or control shares of any of the equities mentioned in this column. He did not own short positions in any stock mentioned in this column.

Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;

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