Transportation and Automotive Sector Ideas

[gfp927z]

>>> Railroads Make Up 36.7% Of This Transportation ETF


Seeking Alpha

Oct. 09, 2020

by Sven Carlin


https://seekingalpha.com/article/4378292-railroads-make-up-36_7-of-this-transportation-etf


Summary

Railroads are good businesses with a strong moat, high profitability, good growing dividends and buybacks that push stock prices higher. It is likely railroad stocks will keep being the stable ones within the transportation ETF.

The buyback game is a risky game to play and can't be played forever. The key is to sell at some point in time before the debt becomes a burden.
At the bottom of the article you have a video discussing the topic if you prefer watching.

We all know Warren Buffett owns a railroad, Burlington Northern Santa Fe. Therefore, it is always good to look into railroad stocks to see whether a railroad stock might fit your portfolio too. A way to get exposure to railroad stocks is the iShares Transportation Average ETF (IYT) as 36.7% of its weight consists of 4 railroad stocks:

Norfolk Southern (NSC)

Union Pacific (UNP)

Kansas City Southern (KSU)

CSX Corp. (CSX)

This article will describe the investment thesis for railroad stocks, give an overview of all railroad stocks traded in the US, discuss the main trends within the sector, the valuation and the risks of investing in them.

Railroad stocks investment thesis – Moats, Growth & Profitability

The 4 key ingredients that make something a great business to own are moat, growth, increasing profitability and fair price. We analyze the moat strength of railroads, the growth opportunities, profitability and valuation.

Railroad stocks offer a moat

A railroad is a typical Buffett business. Over the last few decades the sector has consolidated and the number of railroads fell from 40 to 7. Each railroad has its own geography and nobody wants to build new railroads because that would impact the profitability of the other and your own railroad. Once you build it, you own it and you can enjoy the economic benefits of it without worrying that somebody will build a new one next to you.

It is unlikely anybody could get permission to build a big, new railroad (not in my backyard) and it is also unlikely a new railroad would ever be profitable because of the competition. Therefore, we can say railroads have a wide moat.

Railroad stocks offer growth and sustainability

When you have a moat, and a stable infrastructure, the more business you do using your infrastructure, the more money you make because your costs increase less than your revenue, thanks to the fixed cost part.

The Association of American Railroads predicts a 30% increase in U.S. freight movements by 2040. That is not much per year, but when you have a moat, when you don’t need to worry about competition too much, when you can focus on reducing costs, improving operations and increasing profitability as much as possible, it adds up to significant profitability increases.

Rail is already the most efficient way to move freight as a gallon of fuel can move a ton of freight for 470 miles on average.

The fuel efficiency makes it also environmentally positive to move things with trains.

We have discussed how railroads offer a moat and growth. But that is not enough to make them a good investment. What you need are profitability and a good price.

Precision Scheduled Railroading Increases Railroad Profitability + Scale

Since the Staggers Rail Act of 1980 that deregulated railroads, railroads spent more than $710 billion on their infrastructure. They did that because it was profitable to do so. The average railroad had returns on capital employed between 7% and 13% over the last 15 years where the returns even increased over the last decade as more and more railroads implemented Precision Scheduled Railroading.

High profitability, a moat, stable businesses, a good return on capital and a focus on rewarding shareholders have pushed railroad stocks to extremely high levels.

Railroad stocks performance and valuation

Actually, over the last 5 years, all railroad stocks have beaten the S&P 500.

Railroad stocks performance over the last 5 years

What happened happened, and there is nothing we can do about it. What we have to do is see how railroad stocks fit our portfolio now. The best way to value a business like a railroad is to look at cash flows and future growth opportunities.

I have compiled a table that compares all railroad stocks and the free cash flow yield is between 3% and 3.7% except for CSX, but that might be due to the coal exposure CSX has, thus it can be considered riskier. If you are interested in individual analyses you can find all the links below.

Railroad stocks dividends and buybacks

All railroad stocks pay a dividend but their key focus is buybacks. All listed ones take on as much debt as possible in order to do as much buybacks as possible. This is probably the reason why railroad stocks have outperformed the S&P 500.

However, as they are taking on more and more debt to do buybacks at any price, as investors we have to be careful to get out in time because when the buybacks stop and liquidity dries up, railroad stock prices will likely crash. So, enjoy the ride while it lasts and see how holding a business with a yield slightly above 3% but relatively safe fits your portfolio.

3% free cash flow yield as valuation metric

A good valuation metric for railroad stocks is also what would a railroad be worth to an owner. Recently KSU rejected a takeover bid for a free cash flow yield of 3%. Thus, we could see that as a margin of safety in this environment. Investment funds that can borrow at below 2% see railroad stocks as attractive when those offer long-term growth and a 3% cash flow yield. However, I don’t think many can come up with more than $20 billion to buy the bigger railroads, so the investment thesis with the bigger railroads is based on the cash flow yield and buyback activity.

Railroad stocks investment thesis

The investment thesis depends on what perspective you take; a relative or absolute perspective.

From an absolute investing perspective, railroads offer a 3% cash flow yield in the form of dividends and buybacks, slow growth alongside a strong moat. Nothing wrong with their businesses and it is likely in 20 years everything will look the same with improved profitability and likely even more traffic. The debt piled up might be an issue if interest rates go up, but interest rates going up is also unlikely for the short to medium term. So, we have safety and quality alongside a yield between 3% and 3.7% on average.

From a relative perspective, with your bank giving you miserable returns on savings, with investment banks and hedge funds being able to borrow at ridiculously low rates, if the market starts liking railroad stocks with a 2% free cash flow yield, that will represent a 50% upside from current levels. Plus, all the buybacks might make it much easier for railroad stocks to go up and do well. Actually, I think that until the buyback game lasts, railroad stocks will likely outperform the market.

Further, with the Fed saying it will allow inflation and railroads focusing on cost savings, their actual margins might improve especially as interest rates on debt stay low. So, railroads could be a safe bet to add portfolio protection against the loose monetary environment we will likely have the coming decade.

Railroads go for automation that lowers costs and improves safety

I hope to have given you a good perspective on railroad stocks so that you can compare them to other investment opportunities you have and see what is the best investment that will lead you to your financial goals – that is the key, nothing else matters.

Railroad stocks as part of IYT

For now, railroad stocks give the necessary stability to IYT as the dividends haven't been cut in this environment and the buybacks stay strong. However, the buyback game can only last up till a point.

One day, there will be no liquidity to take on more debt, or perhaps in a bad economy cash flows will dry up. At that moment in time, there will be no fundamentals and no buybacks to protect the stock price. That is a time to avoid being a shareholder and unfortunately an ETF cannot protect you from that. Despite having 36.7% of its weight in railroad stocks that have all outperformed the S&P 500 (SPY) over the last 5 years and decade, IYT has underperformed SPY.

The point of this article was to give you a good perspective on what you own when you own the IYT ETF, explain the risk and rewards so that you can see whether you have better options for your portfolio. Railroads contribute a 3 to 3.7% free cash flow yield and strong buybacks alongside business stability. On the risk side, all take on debt that pushes the stock higher and forces the ETF to buy more due to weight requirements. Be careful not to be on the other side of that financial engineering game.

<<<