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.
Value Investing Episode 1 – Introduction and Membership Program
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.
From the Lessons Learned article posted a few days ago, in order to gain higher returns, the investment model needs to have greater dispersion with my buy/sell trigger points in its model. Last year, the buy/sell triggers for Union Pacific were a 17% market price decrease from the prior peak and to sell at 100% of prior peak.
This purchase point is driven by the model update whereby market price decreases must hit 18% decrease and the sell point increases to 102% of the prior peak price. This post covers the model update and the associated dollar amounts tied to Union Pacific.
With options, an owner of stock fears a sudden steep drop in price and thus they may purchase an option called 'PUTs' to force someone to buy the stock at a preset price. The key for the owner of a PUT is to set a floor price for their existing stock position. A seller of a PUT desires to own the stock at a certain price if it can get there.
Value investing is about buying low and selling high. The investor creates a model to set buy/sell triggers and exercises this program with investmetns. Back on October 29, 2020, the Railways Pool of the club's Value Investment Fund purchased 114.9557 shares of Union Pacific at $173.98 each including a $1 per share transaction cost. In that post, the sell point was set at $215.17 which occurred this morning in the market. Union Pacific actually cleared $221 at one point this morning.
The fund's preset sell, automatically sold when the price hit $215.17. The fund netted $214.17 per share after paying a $1 per share transaction fee.
The return on the investment is $40.19 per share as follows:
In keeping with the value investment fund's pattern, on Friday the 29th of January, 2021 the Fund sold 113.6363 PUTS on Union Pacific Railroad. These PUTS have a strike price of $175 and are currently sold at $6.24 each. The Fund netted $5.24 each after a $1 per PUT fee. Total realized value equals $595.45 (113.6363 * $5.24). See the table below.
Union Pacific Railroad's current market price is near $200 per share and peaked on January 8, 2021 to $221.28 per share. Thus, owning such a high quality company at $175 per share is desirable. During 2020, this Fund bought and sold Union Pacific twice. In February of 2020, the Fund bought Union Pacific for $157 and sold in June for $183 netting a good return in a short period of time. In October the Fund bought Union Pacific for $174 each and sold the first week of January 2021 for $215 per share; again earning a good return on the investment.
Historically, Union Pacific rarely has the necessary deep drops in market price and then market recovery in a short period of time (less than six months). It is simply one of the best stocks out there to own. The company has very stable earnings, an excellent record of good operations and is considered the best run railway of the six Class I publicly traded railways. If the market price were to dip to $175 per share, market recovery to $215 per share would most likely occur within six months. But even at one year, the return on the investment would equal 21.6%.
Union Pacific is a high quality stock. Over the last twenty years, this company has never failed to earn a profit. During this time period, there have been two recessions. The simple fact is that Union Pacific is a solid investment. The company has paid a dividend for the last thirty years. Its current yield at $210 per share is 1.83%.
Union Pacific's intrinsic value is estimated at $185 per share. Thus, any opportunity to own Union Pacific for less than $185 per share is considered an excellent buy.
From the Lessons Learned article for the Value Investment Fund's 2020 performance, one of the additional tools to leverage higher the Fund's annual return is to sell PUTs. A PUT is an option for the holder of the PUT to sell an asset, in this case stock, for a preset price referred to as 'Strike Price'. The seller of the PUT is basically selling an insurance policy that if the market price drops to the strike price, the seller of the PUT is willing to buy the stock at that price. PUTs are a viable alternative to owning stock at less than intrinsic value.
Dividends and earnings analysis is one of the core requirements of calculating intrinsic value via security analysis. There is a relationship between dividends and earnings; one is a function of the balance sheet, the other is tied directly to the financial performance of the company as reported on the income statement. In general, there must be earnings in order to pay dividends. Investors, especially those holding common stock want rewards for their investment and often, are short-sighted when it comes to receiving dividends. Earnings reflect the power of the company to generate value for the investor. With value investing, the key tenet is to buy a security at as low of a price as allowed by the market and then sell this security at the highest price. In the interim, dividends serve as compensation for a value investor's patience while waiting on the market price for the security to recover to a reasonable high price.
Railroad stocks are unique. This is one of the few industries whereby all the players have a very similar revenue and cost of production business matrix. There are exactly six publicly traded Class I Railways in North America. All of them have to play by the exact same set of legal compliance requirements; utilize the same physical and technological systems; and cooperate with each other to transport goods across the continent. Interestingly, all six have similar financial characteristics:
All generate a profit, the lowest net profit within the group is 22.8%;
All have positive operational cash flow and good free cash flow;
All issue dividends to their shareholders;
All have gross profit margins > 34.5% with the average over 37%;
All have low administrative overhead generating high operational profit margins; AND
All have similar 10 year growth lines related to share price.
One of the metrics that separates them from one another is their dividends and earnings relationship. Performing a dividends and earnings analysis gives a slight advantage to the value investor over traditional traders and in some cases, if the analysis is done properly and timely, a distinct advantage over professional traders. This particular article is in-depth and educates the investor about this aspect of security analysis for this one industry. The opening section introduces the relationship of dividends and earnings with business in general. There are certain key principles that bind these two financial items together. Understanding this interrelation is key to application of determining value for a company. With this understanding, the second section below develops the railways industry as a whole. It looks back over the last ten years of actual dividends and earnings for all six railroads and analyzes their trends. Here, the impact of this relationship and how it affects the stock market price for the industry as a whole is evaluated.
The final section explores each company individually and explains how this dividend and earnings analysis impacts each company's respective intrinsic value. The goal is to assist with determining reasonable relationships to the actual stock market price for the company's shares. The end result is security analysis for each railroad stock as it relates to the dividends and earnings.
Understanding the relationship of dividends and earnings is essential as one of the value investment metrics used by value investors when determining intrinsic value along with expected market highs and lows for a particular stock.
Every student of investing is taught the core principle of discounted cash flows. This business principle is also used with intrinsic value. Application of discounted cash flows assists value investors in determining intrinsic value. Academia, major investment brokerages and the majority of investment websites place unquestionable belief in this single formula to equate value for a security. The problem here is that all of them forget or ignore the underlying requirements to use and rely on the outcome of the formula's solution. In effect, with intrinsic value and the application of discounted cash flows, there is a very narrow set of highly defined parameters whereby this tool is applicable. Used outside of this framework, the result's reliability quickly drops to nearly zero, like either side of the bell curve.
This article starts out by identifying the highly restrictive requirements to apply discounted cash flows. There are at most 20% of all marketable securities where this formula succeeds in determining intrinsic value. Secondly, the formula is explained to the student and why it is so important to apply it properly. There are several terms and values the user must include in the formula; this section explains them in layman's words.
The third section below goes into the corporate financial matrix to explain how to determine cash flows. Furthermore, cash flows are just not the past year or years; it is really about future cash flows. How do you equate something in the future?
The final section puts it together when determining intrinsic value. Unlike what others state, intrinsic value is not a definitive value; it is a range. The job of the value investor is to narrow that range to a set of values that are reasonable and effective with generating gains with the value investor's mindset of 'buy low, sell high'.
The overall goal of value investing is to buy a security at less than intrinsic value, commonly referred to as creating a margin of safety; then waiting for the market price to recover to a reasonable high and then selling that security. The depiction here illustrates this concept well.
The most popular and improper method to determine intrinsic value is the discounted cash flows method. It was advocated in the book Security Analysis written by Benjamin Graham and David Dodd, the fathers of value investing. However, most so called experts didn't read the entire book. Graham and Dodd only used this method under certain conditions. The same conditions as explained in the first section below. They strongly encouraged calculating intrinsic value from the assets valuation perspective (balance sheet basis) and not as a function of earnings plus cash adjustments (cash flow).
Within the railways pool of investments for the Club's Value Investment Fund, Norfolk Southern Railroad is considered one of the better investments of the six existing railroads in the pool (soon to be five with the merger of Canadian Pacific and Kansas City Southern). It is a highly stable company and rarely performs poorly, either financially or via key performance indicators. Thus, the sale of PUTs on Norfolk Southern Corporation are a safe and relatively low risk options investment.
A PUT is the sale of an insurance policy to an existing holder of stock. The idea is that IF the market price for the stock should suddenly depress to a particular price, 'Strike Price', the current holder of the stock can force the seller of the PUT to buy the stock from the current owner of the PUT at that strike price. In effect, the PUT acts as a floor price for the stockholder.