Buffett's Favorite Income Investment

In 1977, a newspaper from Buffalo sued Warren Buffett.

At the time, Buffalo had two newspapers. Warren Buffett had just bought the Buffalo Evening News. The Buffalo Courier-Express was worried Buffett was trying to run it out of business to get a monopoly on Buffalo's advertising revenue.

The judge agreed and ordered an injunction against Buffett's newspaper. 

"There are only two newspapers now," said the judge. "If [Buffett's] plan works as I find it is intended to work, there will be but one left."

Before the Internet and local television broadcasting, a single newspaper in a medium-sized town like Buffalo was a great business. There was no other way for businesses to contact their customers, so the newspaper was like a "toll bridge" connecting businesses and potential customers. It could raise advertising rates – tolls – through the roof, and businesses wouldn't be able to do a thing about it. 

But sharing the market with another newspaper is a lousy business. Buffett had no pricing power and only half the customers. So Buffett bought theBuffalo Evening News and tried to bankrupt his only competitor. The judge's injunction lasted for two years until the appeals court overturned it. In 1982, the Buffalo Courier-Express went out of business, and Buffett's newspaper started making huge monopoly profits.

Toll- bridge businesses are Buffett's favorite businesses... especially when they operate in uncompetitive markets. He invested in ABC television in 1979, when there were only three networks. American Express is another famous Buffett investment. It's a toll bridge collecting interest from consumers and fees from merchants for using Amex's payments system. 

Notice all these businesses have the same characteristics. They all provide basic services. And after the initial costs of building the toll bridge, these businesses don't require much money to operate. The fees they collect are all profits. And they're hard to compete against. The upfront capital costs are huge, half the market is the best a competitor could hope for, and they won't have any pricing power unless they can afford to bankrupt the competition like Buffett did in Buffalo. 

In The 12% Letter, we've invested heavily in low-competition toll-bridge businesses. They make excellent income investments. Because they don't have any major operating costs, management can pay out almost all the fee income to shareholders as dividends. Toll bridges are excellent inflation hedges, too. The upfront costs can be financed and paid back in devalued dollars over time like a mortgage, but the revenues rise with inflation. 

My favorite kind of toll bridge is a pipeline company. These businesses move natural gas around the country in steel tubes buried six feet underground... an essential service that costs next to nothing to maintain. There's never any competition. And there's no commodity risk. No matter what the price of natural gas, the pipeline operator simply collects tolls. Plus, you've got the government on your side, giving large tax breaks to encourage investors.

The bear market has destroyed pipeline stocks. The Alerian MLP index is an index of the 50 largest pipeline companies. The index yields 10.5% right now, but it's easy to find individual pipeline companies with yields as high as 15%.Click here for a list of the pipeline companies in the index. 

Good investing,

Tom