2010: How would Buffett calculate "allowable returns" in the railroad industry?

ANDREW ROSS SORKIN: This question relates to your investment in Burlington Northern, and it comes from Josh Sanbules (PH), who I believe is in New York City.

And he asks, “You mention in your annual letter that regulators of the railroad industry need to provide, quote, ‘certainty about allowable returns,’ unquote, in order to make huge investments. If you were going to help the regulators calculate, quote, ‘allowable returns,’ how would you suggest they do it?”

WARREN BUFFETT: Well, I think the Service Transportation Board — and maybe Matt Rose could help give more details — but I think they’ve adopted something like 10 1/2 percent, or thereabouts, on invested capital.

And if you had a major enough change in interest rates or something, you could argue that there should be some adjustment, perhaps, in one direction or another.

Usually, in the case of regulated utilities, they talk about return on equity. And you have different amounts in different states, but some states it may be 11 percent, in some states it may be 12 percent or something like that. It’s usually in that range.

With the railroads, they’ve gone toward this return on invested capital, which includes debt as an adjusted figure.

And I don’t think that’s a crazy, crazy standard. I mean, the railroad, unlike the electric utility, when you get an allowed return in the electric utility you’re almost certain of earning it, I mean, if you behave yourself. And your demand is never going to fall off that much, probably, that you’ll go way below your return.

The railroad’s got more downside in it if you run into a terrific industrial recession, so you’re not as protected on the downside.

But there should be some figure, and I would argue that the 10 1/2 percent, or whatever it may be on invested capital, that’s been achieved by the four big railroads in recent years, something close to that or right around that figure.

And you want the railroads investing a whole lot more than depreciation, and I would think that would be — it’s certainly an inducement to me to invest money in improving the transportation system.

And on the other hand, if that return were far lower than that, it would be crazy to put money, because you can’t change that railroad system and do something else with it.

So I think the country and the railroad systems have a very common interest in not earning exorbitant profits or anything like that, but getting a decent return on what is sure to be much needed investment over the next 10, 20, 30 years.

And I’d go along with — if the Service Transportation Board says 10 1/2 percent, or some number like that, I think that’s not a crazy number.

Charlie?

CHARLIE MUNGER: Well, yeah, the railroads have been a hugely successful system, in terms of a regulated business. If you stop to think about it, the railroads of America have been essentially totally rebuilt in the last 30 or 40 years.

They’ve improved the tracks, they’ve changed the size of the tunnels, they’ve improved the bridges. The average train can be more than twice as long and twice as heavy.

And you can hardly imagine a business that’s done a better job in adapting to the needs of the rest of us than the American railroad industry. And that’s by and large been a system of wise regulation accompanied by wise management. And that was not always the case.

If you go back a long time, neither the management nor the regulation was all that wise. But the existing system has worked very well for all of us.