Buffett Buys a Railroad: What Does It Mean for Investors?

11/03/2009 07:21 pm ET | Updated May 25, 2011

Berkshire Hathaway just made its largest acquisition ever, buying Burlington Northern Santa Fe Corporation, a railroad company, for over $35 billion. This is a large bet by the most successful investor of all time that the US economy will improve and prosper.

Actions speak louder than words. What does that action mean for investors? For one thing, it reflects Buffett's confidence in the prospects of the economy, prospects upon which a railroad company depends. And Buffett is convinced that economic activity will pick up. In fact, he is confident enough that he is willing to use debt and issue Berkshire shares, two methods he had only used sparingly in the past, in order to close the deal.

This should also tell you something about valuations in general, particularly those of large cap stocks, and especially in comparison to other available investment alternatives.

In the last nine years, U.S. equities have lost almost half of their purchasing power (adjusted for inflation). Treasury bonds have done much better. Because it is easy to extrapolate the most recent past into the future, so many people are now gloomy about the future prospects of equities.

But history shows that past periods where bonds outperformed stocks have been great times to buy stocks.

According to Jeremy Siegel from the University of Pennsylvania, in all previous cases of 10-year periods where stock returns have been negative, subsequent 10-year returns were over 10% real, more than double the return of government bonds.

So every time stocks have performed poorly for 10 years, they have performed better than average for the next 10 years, and beaten bonds by 2 to 1 on average.

In the 20th century, not exactly a calm, worry-free period, stocks in America had a real (inflation adjusted) return of 6.9% a year, versus 1.5% for Treasury bonds.

Yet in 1932, investors were melancholy about stocks. The entire world was in depression, capitalism seemed like a failed experiment, unemployment was 25%, and Nazi Germany was advancing. But the S&P rose 34.8% a year over the next five years.

And in 1949, U.S. budget deficit as a percent of GDP was much higher than it is today, communism was spreading, and the Soviet Union was threatening a nuclear annihilation. Stocks rose 23.2% a year for the next five years.

The past decade was the worst for stocks in 70 years. We just experienced the most severe recession since the Great Depression ended. And I believe our experience in the coming decade will be similar to the historical examples above. If stocks revert to their 20th century mean, they will post high real returns, and significantly outperform bonds.

And Warren Buffett is betting that way.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at