In this blog, we review the characteristics of the railroad industry and why we believe it complements the Reaves investment universe. Those characteristics include: the essential nature of the industry to the economy, high barriers to entry, strong competitive advantages, and a history of steady cash flow and earnings growth.
Railroad Companies’ Networks Are Nearly Impossible to Replicate
At Reaves, we first started researching railroad stocks more than a decade ago because they were an essential service industry. From a risk perspective, they were also a nice complement to other stocks in our portfolios for which falling commodity prices were a headwind. Railroads typically benefit when energy prices fall because fuel is a main cost input for the business.
Competitive advantages for dominant companies in the industry were always clear. There are powerful barriers to entry in networks that were essentially built at the turn of the century and are now impossible to replicate. There is really no other cost-competitive option for coast-to-coast bulk shipping.
The industry is also heavily regulated. Given our history in other highly regulated industries such as utilities and telecom, we concluded that understanding and digging into the regulatory backdrop could give us an advantage as investors.
Perhaps most important, we saw that the industry was still in the early innings of improving monetization of its valuable railroad assets.
Precision Scheduled Railroading: An Operational Paradigm Shift
In the early ‘90s, a little-known railroad company started making big industry changes. Under the leadership of CEO Hunter Harrison, Illinois Central Railroad introduced a concept called Precision Scheduled Railroading, or PSR.
The revolutionary concept meant that trains would operate on a fixed schedule, rather than leaving a station once a train has a sufficient number of loaded cars. PSR also simplified routes, with more direct routes to larger stations and fewer transfers at smaller transfer stations.
The changes translated to more reliable service, and coincided with manufacturers’ implementation of “just-in-time” manufacturing concepts, which called for leaner inventories and efficient delivery of inputs and outputs. Due to their increased reliability, railroad networks were soon adding more businesses as customers.
At the same time, operations were improving. PSR meant using less fuel, fewer workers, and closing smaller transfer stations, moves that improved operational efficiency and profitability. As Illinois Central’s practices were adopted by other railroads (in varying degrees and time horizons depending on the company) railroad company operating margins improved significantly. This has led to substantial earnings and cash flow growth across the industry.
Other Innovations Will Follow PSR
While PSR has led to significant operational improvement, we believe there is plenty of modernization still to come. Technological enhancements that allow trains to operate with a single engineer as well as adoption of automated track and car inspection could continue to power better efficiency for many years. These improvements could boost earnings growth in good times and help the companies better withstand downturns in bad times.
We believe investors could benefit from studying the railroads as these and other technological improvements progress and enhance the industry’s competitive advantages.
Disclosures:
Reaves Asset Management is an investment adviser registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940. Registration does not imply any skill or training. Reaves is a privately held, independently owned “S” corporation organized under the laws of the State of Delaware.
The information provided in this blog does not constitute, and should not be construed as, investment advice or recommendations with respect to the securities and sectors listed. Investors should consider the investment objective, risks, charges and expenses of all investments carefully before investing. Any projections, outlooks or estimates contained herein are forward looking statements based upon specific assumptions and should not be construed as indicative of any actual events that have occurred or may occur.
Past performance is no guarantee of future results.
All investments involve risk, including loss of principal.
All data is presented in U.S. dollars.
Important Tax Information: Reaves Asset Management and its employees are not in the business of providing tax or legal advice to taxpayers. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax adviser.
