Should You Buy Railroad Stocks? The Complete Answer (Comparative Table)
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.
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 give you a good overview on the key factors you need to make an investment decision.
The 4 key ingredients that make something a great business to own are a moat, growth, increasing profitability and a 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 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 new big railroad (not in my back yard) 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 more 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 is profitability and a good price.
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 has 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.
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 stock 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 are 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 an 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.
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 would represent a 50% upside form current levels. Plus, all the buybacks might make it much easier for railroad stocks to go up and do well.
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.
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.
A great example explaining the difference between absolute value investing and relative investing is Buffett’s Burlington Northern business approach compared to how all other railroads operate and make investment decisions.
(article to come)
In this article on Buffett, Berkshire and Burlington I explain the key investing question an investor needs to have answered; Am I going to follow the crowd, hoping that stock prices go up or invest for myself, be a business owner and compound earnings long-term and actually hope stock prices go down? Sounds ridiculous? Read the article or watch the video, but be careful, it might change your life!
For more information on other railways stocks, please check my comparative railway stocks article with links to detailed analyses such as this one.
Transportation stocks at multi year lows are airport stocks, another sector I have analyzed lately.
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