Warren Buffett Just Issued a Dire Warning for These 2 “Bulletproof” Sectors

Warren Buffett just released his annual letter to Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) shareholders, and in this investor’s eyes, it was his best in years.

Aside from the fitting tribute to longtime partner Charlie Munger, who passed away late last year at age 99, Buffett expounded on Berkshire’s investments in a way he hadn’t in many years.

It wasn’t all good news, though. In fact, there were some chilling warnings on two of Berkshire’s largest businesses: BNSF railroad and Berkshire Hathaway Energy. But the warnings weren’t company-specific; rather, the adverse developments were relevant to investors in any railroad or utility stock.

Safe havens no more?

Why have railroads and utilities been heralded as “safe” investments in recent decades? One factor is that the massive investments needed to build and maintain railroad and utility infrastructures make for very high barriers to entry. In fact, it’s almost impossible for new entrants to challenge these wide-moat businesses.

That’s why there’s typically only one utility — maybe two for populated areas — in a given geography, essentially giving these companies monopoly or duopoly status. That’s also why there are only six major railroads covering all of North America.

Obviously, electricity is a necessary good all people need in greater and greater amounts. And railroads are often the only economic and lowest-carbon method of transporting various heavy goods long distances across the country.

No wonder Buffett bought into these two industries heavily when he had the chance — they provide essential services with near-impossible barriers for competition. Who wouldn’t want to invest alongside him?

The problem with railroads

A problem with both industries, especially railroads, is simply staggering and rising costs. Railroads require massive capital outlays to merely maintain their enormous infrastructure, and a tight labor market makes it difficult to attract workers without big pay increases. Moreover, though railroads may find solid demand transporting goods one way, they often have difficulty matching enough goods to transport on the way back.

Two other modern phenomena, climate change and work-from-home culture, exacerbate these problems. Increasingly intense storms wear on tracks and bridges, with Buffett specifically mentioning in his letter that “flooding can be a nightmare.”

Buffett also lamented the hiring environment, especially for a job that has “difficult, and often lonely, employment conditions,” with contentious negotiations between railroads and unions often getting resolved in Washington. Buffett noted that even as revenue fell last year, workers were given pay raises “far beyond the country’s inflation goals. This differential may recur in future negotiations.”

Aside from earnings pressure from rising costs and challenged revenue, even headline earnings for all railroads are also likely overstated. Construction inflation has meant railroads have had to invest far greater sums than their depreciation (reflecting spending in prior years) just to maintain the same level of business. Buffett noted, “This reality is bad for owners, whatever the industry in which they have invested, but it is particularly disadvantageous in capital-intensive industries.”

Indeed, the five other publicly traded railroad companies appear to have the same problem, with cash flows tracking well below generally accepted accounting principles (GAAP) earnings:

Sources: Company 2023 annual reports or Q4 2023 earnings releases, Yahoo! Finance. Numbers in millions. Free cash flow = 2023 operating cash flow – capital expenditures. P/E = price to earnings. P/FCF = price to free cash flow.

Railroads will be a viable business for a long time to come. However, those invested in public railroad companies should probably acknowledge that you’re likely paying a much higher “true” valuation for them, as indicated by their high price-to-free-cash-flow ratios that are uniformly higher than their headline earnings multiples.

Utilities: recession-proof, but lawsuit-proof?

In addition to railroads, Buffett has made a big bet on utilities, beginning with his purchase of MidAmerican Energy back in 1999. From there, Berkshire acquired more and more utilities and renamed the energy conglomerate Berkshire Hathaway Energy, spanning several utilities across the Western and Midwestern U.S., as well as the U.K. and Canada.

Why did Buffett like utilities? For a guaranteed return on a large amount of capital deployed. Throughout the history of utilities, states and regulators would agree on an acceptable return on invested capital for utility companies in exchange for utilities investing the massive amounts needed to build their power and distribution infrastructure.

But Buffett lamented that California had broken with that orthodoxy with a negotiated bankruptcy of California’s largest utility, Pacific Gas and Electric, in 2019 and that Hawaii may do the same regarding Hawaiian Electric due to last summer’s deadly wildfires.

The potential negligence or unwillingness to update expensive infrastructure on the part of those utilities, combined with wildfires and other catastrophic weather being exacerbated by climate change, is changing the calculus for some states and courts, given the immense costs of the damage done by these disasters.

However, Buffett laments that if utilities are held liable and prevented from earning an acceptable return on their investment, utility stocks “might no longer attract the savings of American citizens and will be forced to adopt the public-power model.”

Adding insult to injury, Berkshire disclosed in its annual report filed last weekend that the U.S. federal government is now threatening to sue BHE’s Pacificorp for $1 billion for its potential liability in the 2020 wildfires in Northern California and Oregon. The lawsuit is to recover costs to state fire departments and the U.S. Forest Service for damages and cleanup. And keep in mind, this would be on top of the $300 million Pacificorp already agreed to pay to settle a lawsuit from individual victims of the disaster late last year.

Utilities are often considered “safe haven” stocks in trying times due to their monopoly-protected status and guaranteed returns on investment no matter where we are in the economic cycle. But the economic cycle is just one risk, and it appears climate change, lawsuits, and changing government positions may be even worse threats. With a limited upside and huge potential liability, why would investors want to own utilities?

If you do own one or more utility stocks, you need to factor in this potential liability due to a natural disaster in that geography, as well as the political climate toward business in the utility’s given state. Otherwise, Buffett seems to think you should steer clear of investing in utilities as he did:

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William Duberstein has positions in Berkshire Hathaway. The Motley Fool has positions in and recommends Berkshire Hathaway and Canadian Pacific Kansas City. The Motley Fool recommends Canadian National Railway. The Motley Fool has a disclosure policy.

Warren Buffett Just Issued a Dire Warning for These 2 “Bulletproof” Sectors was originally published by The Motley Fool

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