Disclaimer: This is a high level conceptual exercise and all figures are approximations using the CY2020 accounts.

In early 2010, Berkshire Hathaway finalised the acquisition of BNSF (Burlington Northern Santa Fe), the largest US based railroad for the consideration of $26 billion for the stock it did not already own. This equated to a total deal value of $34 billion.

The consideration of $26 billion was paid with ~$16 billion in cash and the balance in Berkshire stock; with around $8 billion in debt drawn to partial fund the cash consideration. Broadly, this structure was in line with Berkshire's target leverage of around 30% against assets.

Berkshire's operandi modus is to let competent management teams run their businesses but enforcing strict capital discipline with a strong focus on cash generation to the parent company. Optimal capital allocation decisions result in a large advantage over time, which Berkshire personifies in many ways. 

Without digging too deeply into the operational performance since acquisition, it is clear that Berkshire purchased BNSF at a cyclical low with extraordinary timing; just as the post-GFC recovery was gaining momentum. The growth in top-line revenue has been anemic, with a rise of only around 25% over the 10 year period since acquisition. However, cost control, capital allocation and market conditions have been sound and allowed Berkshire to harvest outsized returns from the investment.

Since acquisition, Berkshire has invested $41 billion in capital expenditure offset by depreciation of $20 billion. This implies that BNSF may have been either 1) under-investing in capital items prior to Berkshire's acquisition or; 2) Berkshire have invested heavily in capital items due to a strategic rationale. 

The latest Berkshire shareholder letter provides some clues: "Railroading is an outdoor sport, featuring mile-long trains obliged to reliably operate in both extreme cold and heat, as they all the while encounter every form of terrain from deserts to mountains. Massive flooding periodically occurs. BNSF owns 23,000 miles of track, spread throughout 28 states, and must spend whatever it takes to maximize safety and service throughout its vast system."

Whilst depreciation is a relatively stable portion of fixed assets; year-to-year capital expenditures can fluctuate more broadly depending on capital allocation decisions and any externalities that may impact the operations. In addition, given the relatively long-life nature of heavy fixed railway assets and the inexorable push of inflation over time; this effectively means that a dollar spent today, could mean over a dollar saved tomorrow in aggregate holistic costs.
Accordingly, we anticipate that BNSF will require a relatively lower capital requirement going forward, probably a figure closer to BNSF's depreciation and amortization expenses.

Incidently, this aggressive capital investment program has come about despite almost $42 billion in dividends paid to Berkshire over this time period. No doubt that a reasonable portion of this has come from levering up the balance sheet against new fixed assets against which Berkshire has greater certainty around their effective life. None-withstanding, this is a fantastic result against Berkshire's cost base of ~$30 billion. 

The largest component of value attributable to BNSF is the terminal value. The company's claimed equity value on its books is around $65 billion which looks to be under-valued on a standalone basis. For instance, BNSF's competitor, Union Pacific Corporation (UNP), is valued at around $154 billion at a capitalised dividend yield of approx 1.8%. 

I cannot say whether UNP has invested the minimum requisite capital expenditure necessary to keep its operations running smoothly, but I can say that BNSF's heavy capital investments provides it a good degree of certainty around its future capital requirements; so it's appropriate to use UNP's dividend yield as a basis for our standalone terminal value. 

For CY2020, a $5.8 billion dividend was paid by BNSF to Berkshire; we expect this to grow over time largely dependent on the sustaining capital requirements. Capitalising this dividend at a yield of 1.8%, provides us with a terminal value of $322 billion. If we are even more conservative and decide to use a 3% capitalisation figure, this provides us with a terminal value of around $193 billion. Both figures are vastly higher than BNSF's claimed book value of $65 billion.

Berkshire's overall return on BNSF has been over 28% per annum in our upper case and almost 23% in our lower case. It's actual return on equity is significantly higher; circa 32% and 27% in upper and lower cases.

These are extraordinary returns considering the size of the investment and truly demonstrate why the Berkshire team are considered the world's pre-eminent living investors.

In private debt funds - unlike in boutique equity funds - there is a big payoff for investors from having a bigger loan book. Scale makes private debt providers more relevant to borrowers and investors, says Metrics Managing Partner Andrew Lockhart.

Conventional wisdom says that by staying small, boutique managers can deliver superior returns. They are nimble and can move in and out of stocks without the burden of having to invest, even when conditions are not favourable.

But what is true of equity managers does not hold for private debt providers. Increased scale makes a private debt manager more relevant to both the borrowers and the investors and provides more consistent returns. In this article we look at the reasons why, using the Metrics Credit Partners experience to illustrate the benefits.

Metrics was established ten years ago, a pioneer in non-bank lending in Australia, by a team of three partners who worked at NAB and who had extensive experience in lending and portfolio risk management. Since then, Metrics has grown to a team of ~100 people with AUM of ~$10 billion. Metrics has not grown just for the sake of getting bigger, but because there are clear benefits for investors.

Having scale makes Metrics more relevant to borrowers because access to non-bank debt finance can help them grow. With increased funding, Metrics can lend larger volumes to clients to help realise their plans. A smaller lender may not always have the capacity to match the needs of some borrowers and they don't have the certainty of capital that a larger lender provides.

Metrics is not a bank. It is a minnow compared to the balance sheets of any of the Big Four. But  it does not have their cost structure or rigid business practices, either. As one of the largest non-bank providers of debt finance to Australian businesses Metrics has the capability to match the needs of borrowers in a way that banks cannot. There are regulatory restrictions which impose a higher level of capital to be retained on balance sheets for banks that lend to business compared with lending for consumer purposes where the loan is secured against a residential property. This reduces the returns that a bank can generate from lending to companies which reduces their appetite to do so. But Metrics is focused on business and real estate lending. It has a highly skilled and a professional team with a deep understanding of each borrower, which means they can assess risk and price it accordingly.

Through the recent wave of lockdowns that began in June 2021 Metrics again demonstrated its commitment to business borrowers. In the September quarter alone, Metrics financed in excess of $1.2 billion. By December, as the economy re-emerges from lockdowns, Metrics expects to finalise another $2 billion. It's unlikely any of our non-bank fund competitors can provide this volume of finance to Australian companies.

All through this period Metrics has further added depth and breadth of expertise, increasing its team ~100 people. By resourcing teams in origination and risk assessment it has a larger more diverse team to consider more lending opportunities. That in turn delivers more attractive returns and capital preservation for investors.

Contrast that with small private debt providers who claim to have the same benefits of a boutique equity investor. Their small scale means they can only do a handful of loans for a small number of clients before they reach capacity. That limits the potential of their borrowers. It also limits the managers ability to create diversified portfolios for their investors, increasing concentration and single large counterparty credit risk.

The big global credit players setting up shop in Australia have a similar scale problem. On the face of it they have huge resources and big, well-known brand names to offer the local market. But the reality is that their local teams are small and lack the capacity to originate many good lending opportunities. When they do find one, the credit decisions are usually taken offshore, away from the relationships and understanding of local nuances that a larger, local private debt manager like Metrics provides.

Being more relevant to borrowers has several important benefits for investors. Scale provides access to better deal flow, giving Metrics a better understanding of the market and the ability to focus on the best quality lending opportunities coming through. Having the ability to lend in larger size also means more negotiating power when determining the terms and conditions on the financing. It allows Metrics to tap sources of income - such as origination fees - that those smaller players cannot, generating better returns for investors.

Scale also provides important risk management capabilities for investors, by allowing diversification across a wide range of industries and sectors. A larger portfolio of loans, where each exposure represents less than 1% of the total, provides cover against any one loan having an outsized impact on the returns to investors. This is also important in preserving investor capital, reducing concentration risk from any one borrower.

Scale is only useful when it delivers better outcomes for borrowers and investors. Metrics' continued growth and performance reinforces this. This year alone, both listed funds have undertaken significant capital raisings to expand their capacity and continue to trade at a premium to their NAV. New additions to the Metrics suite of funds have and will continue to come to market to ensure those benefits of scale are realised for borrowers and investors alike.

When it comes to investing, does being boring ever pay off?

The contrarian approach to investing is not a new concept. If you want to generate returns better than the crowd, you need to be different. 

Against the backdrop of a tumultuous past year and a half, the easiest thing was to play it safe in the light of uncertainty. That's exactly what many people did, including some high-profile professional investors who converted their portfolios to cash in March 2020.

For us, being agile, open-minded and willing to be contrarian was more important than ever last year. It allowed us to invest in a collection of unloved businesses at once-in-a-lifetime prices. 

And it paid off. 

The 2021 financial year was the best on record for Forager across both our Australian Shares Fund and International Shares Fund. 

That was then, what about now? 

The current environment reminds me a lot of 2017. We had had a wonderful few years of outperformance leading up to that year, with many of our contrarian investments paying off handsomely. The following two years, however, were our two worst on record.

When I reflect on that 2018-2019 period, our biggest mistake was to keep being contrarian simply for the sake of it. I wrote an article at the end of 2017 that identified 10 blue chip stocks that made for a nice defensive portfolio in a generally expensive market. Not only did those 10 stocks perform well over the subsequent year, on average they outperformed our Australian Shares Fund by some 20%. 

There is a time and place for contrarian bets. And there's a time for playing it safe. 

Right now, interest rates remain at record lows, stock markets are trading at all-time highs, people are inventing new metrics like revenue multiples to justify absurd prices for growth stocks, inflation is becoming a serious concern and COVID resurgences are weighing on the economic recovery.

More importantly, there are very few pockets of undue pessimism. 

It is time, once again, to be thinking about the benefits of safe and boring. Once again, like 2017, investor obsession with hyper growth and high returns has left some of these stocks neglected.

The beauty of being big and boring

Let's take a look at two big and boring stocks currently in our Australian Shares Fund: Downer EDI and TPG Telecom.

Employing some 52,000 people in Australia and New Zealand, Downer Group is one of the antipodes' largest industrial services companies. Its operations range from maintaining buildings and railway lines through to building roads and runways for the defence force. 

If that sounds boring, that's the whole point. After a number of slip-ups in recent years, the company has been focussing on making itself as boring as possible. It has been winding down its higher-risk construction business, has offloaded most of its mining services businesses and sold its laundries operations for a tidy sum. By 2024, we estimate 80-90% of revenue will come from government-related entities. 

This transformation has gone largely unrewarded by investors. Up until its latest results were released in August, the share price was languishing at 2016 levels. We think it can generate an 8-9% cash return from these prices, is committed to sharing most of that cash with shareholders and should be able to generate growth in line with the wider economy. In a world of expensive assets, that adds up to just fine.

Telcos out of fashion

TPG is earlier in its transformation journey. The original TPG was a popular founder-led business which David Teoh built from the ground up and created a huge amount of shareholder value. 

His final act was to merge with Vodafone, much to Rod Sims ire. The ACCC Chairman didn't like the impact this merger could have on competition and the deal ended up in the courts. TPG won, the ACCC lost and the combined company is now a significant player with more than five million mobile subscribers and two million fixed broadband subscribers.

Teoh has now left the business and the days of rapid growth are well behind TPG. But we think the concerns Sims had about competition suggest a brighter future ahead for the sector.

On the fixed side of the business, margins have been compressed by the transition from reselling ADSL to lower margin NBN contracts. From here on, there is upside in potential NBN price cuts and the networks themselves are starting to bypass the NBN with home 5G wireless devices (my household uses one, it's super fast and was the easiest installation I have ever experienced).

And in mobile all three large players are talking about a "better" pricing environment, with all of them selling new contracts at better than the current average. Sims won't like that, but it is good news for shareholders. 

We think all of this adds up to a business that can generate a cash return of roughly 8% on today's market capitalisation. Unlike Downer, we might need to wait a few years while TPG repays some debt, but shareholders should see most of that paid out as dividends from the 2023 financial year. 

The telco sector is mature, boring and stable, but we will take 8% over most of the opportunities we are seeing today. 

The lesson: you don't always need to be different

Forager's motto is "opportunity in unlikely places". It's an approach that has served us well over the past decade. Despite the odd year of poor performance, our clients are still well ahead of the index since our Australian Fund's inception in 2009. 

We have learned an important lesson from those difficult years, though. You don't always need to be doing better than the crowd.

Keeping it simple is not always easy. Especially when, like us, you have a reputation for being contrarian. To turn to our loyal client base and say "you know how we look for opportunity in unlikely places?". Well, we just bought Downer EDI. That doesn't sit well with how we view ourselves or what our clients have come to expect. And that's what makes it so hard.

But we know how important it is. The contrarian's time will come again. And, while we wait, boring stocks like Downer and TPG can give us some perfectly sensible returns.

Written by Chief Investment Officer Steve Johnson