The transportation sector of the United States economy is composed of nine industrial groups. One particular group moves more volume of tonnage based on ton miles than any other form of transportation – railroads. In accordance with the Federal Department of Transportation, railroads move 39.5% of all freight in the US (based on ton miles which is the length freight travels). It’s a $60 Billion industry with over 140,000 miles of track. It is dominated by seven major carriers (referred to as Class I Railways). Six of these carriers are publicly traded. The seventh is owned by Berkshire Hathaway. A recent announcement by Canadian Pacific Railroad to merge with Kansas City Southern will consolidate this railways pool to five potential investments in the third quarter of this calendar year 2021.
The key to success with this pool is determining intrinsic value. This is one of the few times that the discounted cash flows method is warranted in the intrinsic value formula. Once calculated, given the high stability of earnings, the intrinsic value is adjusted annually about four to five percent higher depending on financial and actual performance in accordance with each railroad’s key performance indicators.
The following articles articulate this railways pool of investments and provide all the decision model justifications, formulas, changes and reasoning for the respective buy/sell model. You must be a member of the Value Investment Club in order to access the respective articles and the buy/sell model. Click here to join: Membership.
Currently, late April of 2021, all the railroad stocks are performing at new historical highs. This has been the case now for almost five months. Historical analysis of railway stocks identifies that they are highly correlated with the overall economy which makes sense given their strong relationship to movement of freight. Thus, in order to have an opportunity to buy, the major indices must have retrenchment of some significant percentage, typically more that 15%. This is when opportunities to buy will come to fruition. Until then, a value investor can only wait.
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The following graph illustrates the performance of the railways pool during the first year. In effect, this pool outperformed the market by a factor of 3.5. Furthermore, it was able to achieve this with only FIVE full cycle transactions.
The transportation sector of the United States economy is composed of nine industrial groups. One particular group moves more volume of tonnage based on ton miles than any other form of transportation - Railroads. In accordance with the Federal Department of Transportation, railroads move 39.5% of all freight in the US (based on ton miles which is the length freight travels). It's a $60 Billion industry with over 140,000 miles of track. It is dominated by seven major carriers (referred to as Class I Railways).
Railroad companies are an excellent group of investments for several reasons. First, this is a highly stable and regulated industry. Secondly, there are a limited number of railroads, in effect, the threshold of entry for any new railways is impractical and financially capital intensive. Third, each company limits its revenue stream to transportation (there are some alternative sources of revenue but they are less than 5% of their entire total revenue). Every single member in this pool has a long history of positive earnings and superior cash flow.
These six are behemoths when it comes to transportation. All have revenues greater than $2.5 Billion per year and hold at least $4 Billion in fixed assets. The key to this investment is the asset allocation model. A common thread that binds all of them is that the asset side of the balance sheet is fixed assets intensive. Basically, more than 85% of the assets are fixed in nature.
Due to this asset structure, there are some business principles every investor should understand because they are applicable to railroad investments. First and foremost is the fixed asset maintenance/upgrade relationship with depreciation expense (allocation of utility value). The next principle is referred to as the break-even point. In general, long life fixed asset driven entities have lower financial break-even points than a traditional company. A third and probably the most influential element of profit for a railroad company is the concept of marginal dollars adding a very high percentage of each marginal dollar of revenue to the profit. The following three sections explain these three principles in more detail related to how they are applied to railroad financials. The final section ties it altogether for the investor as to why railroad investments are a solid and steady investment. Future articles related to this series utilize these three principles when discussing/explaining the respective investment.
Railroad stocks are solid and steady investments. There is limited downside risk and adequate historical data to illustrate buy and sell points for an investor. If properly applied, an investor should earn yields of 18 to 30% year on year. Learn how to develop the investment model for this particular industry.
One of the benefits of railroad stocks is the downside risk. When the stock's share price decreases, it is unlikely it will continuously fall. The business ratios used in this industry assist in understanding how far a share price can fall. The further the price decreases, the more lucrative the investment becomes. Thus, the market - other buyer are enticed to purchase the stock due to the desirable attributes of the stock. The first section below covers this particular aspect of the share price decreasing.
On the flip side are increases in share price. How does an investor know when to sell? If you sell early, you miss out on any additional increases in share price that can add dramatically to your gain upon the sale of the stock. With railroad stock, the historical pattern has rarely wavered from a continuously increasing trend line. The key is to be patient. Yes, the longer it takes to recover and generate gains for the investor, the lower the yield for the investor. Never look at this in isolation, it's about Bernoulli's Law (Law of Large Numbers).
Today is November 15, 2019 and Canadian Pacific Railroad recovered in accordance with my railroad fund investment model to $241.47 per share. The value investing model automatically sold at $241.47 and the price per share continued to climb to $241.86 when the market closed at 4 PM. This sale generated a 9.31% return on the investment over 27 days. Annualized return is > 100%.
Union Pacific's stock carries the highest price to book ratio among the six Class I Railways. It is about a 1.43 times factor over the next best price to book ratio of CSX at 4.73. Strong price to book ratio investments infrequently have deep or extended price depressions. Therefore, an investor must be patient and wait for opportunities to buy. Take note, Union Pacific's price to book ratio is 2.33 times that of Kansas City Southern. This means the buy/sell model is also different; it is actually almost the exact opposite of KSU's model. In KSU's model, the investor looks for opportunity when the price slips more than 5% and then sells once the stock recovers about 12%. With Union Pacific, the investor gets value by waiting on the price to dramatically decrease. The change must be more than 17% decrease. Gains are earned once the stock recovers almost to the prior peak. This peak to peak model takes much longer to cycle through with high price to book ratio investments, but the reward is worth the wait.
To develop a good model, the reader needs to understand why the down aspect of the cycle is where the real value is earned. Unlike KSU's model where the down point to buy is 5% less than the peak, with Union Pacific the down point must be greater. In addition, another section explains that buying in a down cycle more than one time is also lucrative to the investor. Finally, the sell point is set and the corresponding results are calculated. The end result is a model that earns a good return for a high price to book ratio investment.
It's the end of the quarter and time to report on the railroad fund. The fund started on 10/21/19 but I'm resetting the fund's timing to the end of the quarter so that future quarterly reports tie to actual calendar quarters. The market value of the fund is $10,392.74 and I started out with $10,000 71 days ago. Thus, I've earned approximately $5.53 per day since inception. My cost basis is currently $10,270.32 driven by one sale of stock on 11/15/19 and receipt of dividends. Thus, since inception, this fund is growing at a slightly higher rate than 20.13% annualized.
During the last 30 days, the fund held 13.52375 shares (original investment of $2,500) and sold them on 01/17/2020 at 9:40 AM when the price in the market hit the target under the value investment principle at $207.17. The value investing principle (simply stated) required the share price to hit the prior peak price which was $206.46. However, on that morning, the share price instantly jumped past $206.46 to $207.17 triggering the sale of the stock. The gain on the sale net of costs of $1.00 per share to buy and $1.00 per share to sell was $288.19. The stock was purchased on 10/23/19 at $183.86.
Every one of the six railroad stocks are at or above their all-time highs. As of today, February 15, 2020, the various stock prices are as follows: Union Pacific 184.65; Norfolk Southern $206.85; Canadian National $93.93;
Kansas City Southern $173.64; Canadian Pacific $270.86; CSX $79.59.
In addition, the price to book ratios are also higher than last quarter. The key question: is there any value in any of the stocks? To do this, a table of various preferred ratios must be prepared and explained in a write-up.
Two critical points of information are evaluated, both the gross profit margin and operational cash flow per share are explained in this article.
Volatility is necessary to create market fluctuations. Market fluctuations create price disparity for either intrinsic value (buy side of the buy low/sell high tenet of value investing) or price recovery, i.e. unsubstantiated high market prices for stock. The COVID scare is causing the stock market to suddenly drop across the board for all stocks. This provides opportunities to buy low and simply wait for market recovery to sell.