• 6 minutes Trump vs. MbS
  • 11 minutes Can the World Survive without Saudi Oil?
  • 15 minutes WTI @ $75.75, headed for $64 - 67
  • 6 hours Satellite Moons to Replace Streetlamps?!
  • 9 mins U.S. Shale Oil Debt: Deep the Denial
  • 2 days US top CEO's are spending their own money on the midterm elections
  • 23 hours EU to Splash Billions on Battery Factories
  • 3 hours The Dirt on Clean Electric Cars
  • 11 mins Owning stocks long-term low risk?
  • 1 day The Balkans Are Coming Apart at the Seams Again
  • 7 hours Can “Renewables” Dent the World’s need for Electricity?
  • 2 days Uber IPO Proposals Value Company at $120 Billion
  • 2 days OPEC Is Struggling To Deliver On Increased Output Pledge
  • 2 days 47 Oil & Gas Projects Expected to Start in SE Asia between 2018 & 2025
  • 2 days A $2 Trillion Saudi Aramco IPO Keeps Getting Less Realistic
  • 2 days U.N. About Climate Change: World Must Take 'Unprecedented' Steps To Avert Worst Effects
Alt Text

The Dark Horse Of The Oil Price Rally

Vietnam is set to break…

Alt Text

Oil Market Loses Its Bullish Edge

Bullish sentiment has dominated oil…

Leonard Hyman & William Tilles

Leonard Hyman & William Tilles

Leonard S. Hyman is an economist and financial analyst specializing in the energy sector. He headed utility equity research at a major brokerage house and…

More Info

Trending Discussions

World’s Smartest Investor Outperforms With Boring Utilities

Buffett

Warren Buffet doesn't need the likes of us touting his investment acumen. His holding company, Berkshire Hathaway, has compiled a stunning record of achievement over many decades, beating broad stock mar-ket indices handily while acquiring some of the dullest companies in the world. Like other insurance com-panies, Berkshire has very large sums of policyholders money to invest for the long term against future claims. And like other insurers, it's tough to find acceptable lower risk or fixed income investments in this world of ultra-low or negative interest rates and high stock prices.

But several years ago, Buffet began steering Berkshire into investments unusual for a financial concern. He purchased a number of regulated electric utilities and a railroad, the Burlington Northern. These invest-ments have much in common. They provide essential services in slow growing markets. They generate steady albeit modest returns. They require ongoing, large capital investments to maintain current levels of service and, as long as investment takes place, they generate substantial income tax deferrals that can also be invested profitably. Since these businesses are growing, at least in term of their assets--and some level of profitability is virtually assured--the owner or investor can still reinvest their capital at a reasonable re-turn. They don’t have to worry about the vagaries of public markets equity or fixed income. They can in-vest in themselves so to speak.

If Buffet is one of the world’s most successful investors, judging from the above examples, he achieved that title at least in part by only accepting a return that exceeded the risk he believed he was taking. That is, if investment X required a 10 percent return due to the risk inherent in it, and the shares offered a 10 percent return, Buffet kept his wallet in his pocket. But if the investment had a cost of capital of say 9 per-cent but he thought he could earn 13 percent, he was all in. Simply stated he sought a return in excess of his cost of capital.

Okay, so much for the classroom stuff. In the U.S. electric utility industry, recent commission rate orders have been finding that utilities should be permitted to earn around 9-10 percent on shareholder invest-ment. Regulators have determined that figure represents the appropriate cost of equity capital. Related: Why Big Oil Is Shying Away From Mexico’s Latest Oil Auction

Financial theorists, looking at government bond markets in which yields have literally dwindled to nothing on risk free investments, think that the cost of utility equity capital may in fact be closer to 6 percent. (This assumes an equity risk premium of 4 percent over the risk free bond yield of roughly 2 percent.) Clearly there is a wide discrepancy between currently authorized 9-10 percent returns and our postulated 6 per-cent. If regulators come to adopt these lower return levels--down go utility earnings.

Let's get away from depressing financial theory. Instead let’s look at what Berkshire Hathaway actually paid for utility-like assets and what it accepts as a presumably adequate return on its equity. Berkshire Hathaway lumps railroad and utilities together but we believe both the railroad and utility segments have followed similar patterns of profitability. The financial reporting does not spell out everything we would like to know but provides enough data to make reasonable estimates.

We estimate the underlying utility and railroad assets earned decent returns on equity of 9.8 percent in 2015 and 10.0 percent in 2014. But, Berkshire paid a substantial premium over book value in order to buy these assets. On the basis of what Berkshire paid (and Berkshire paid above market prices) we estimate that these investments produced a 6.8 percent return on equity in 2015 and a 7.3 percent return in 2014. (A study earlier this year from Semper Augustus Investment Group indicated that the utilities earned lower returns than the railroad.)

Bottom line? If these returns were not satisfactory, would Berkshire reinvest considerable sums into oper-ations and expand the utility operation through additional purchases? The question answers itself. We see Warren Buffet’s embrace of dull companies offering low returns as another indicator of what the cost of capital really is in the sector. As evidence it is far more compelling to us than a shelf of academic studies on the topic. These seemingly low returns, with their accompanying low risk, appear to satisfy one of the world’s savviest investors. We think that says a lot.

By Leonard Hyman and William Tilles

More Top Reads From Oilprice.com:


x


Back to homepage

Trending Discussions


Leave a comment

Leave a comment




Oilprice - The No. 1 Source for Oil & Energy News