Reaves’ Investment Universe in Focus: The Case for Railroads

U.S. railroads have existed for 200 years, yet the competitive moats around the business remain intact and, in our view, the investment case remains compelling. In this Q&A, Reaves’ Chief Investment Officer, Tim Porter, shares his view on the industry, and what the future holds for it.

What characteristics do rail stocks have that make them attractive investments?

Tim Porter: Like most stocks in our investment universe, railroad companies are true, mission-critical infrastructure businesses, the likes of which, we believe, cannot be replicated. There’s a degree of economic cyclicality to railroad volumes, but at the end of the day, goods and raw materials have to be transported, and there’s no way to do that better than rail. Railroad delivery avoids the unpredictability of congestion associated with truck transport. It is also more environmentally friendly than transporting goods via trucks, ships or air.

On average, railroad stocks advanced by about 23% in 2021.1 How do you gauge valuations today?

Tim Porter: Historically, railroads have traded at a slight discount to the S&P 500 Index, and currently, they are in line with the broader market.2 This is because the industry has become more profitable and has improved return on invested capital. The advent of precision scheduled railroading (PSR) has made railway transportation far more efficient. Through PSR, trains 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 with increased reliability, more businesses as customers.

PSR has also led to operational efficiencies, including less fuel, fewer workers and the closing of smaller transfer stations. In turn, we have seen substantial earnings and cash flow growth across the industry. Going forward, we continue to see potential for growth as companies aim to generate more free cashflow, buy back stock and compound earnings per share at an attractive rate.

What role does management play in your analysis of the sector?

Tim Porter: More than in many other industries, management’s strategy plays a big role in the success or failure of a company. And we’ve seen a divergence between those companies that are well managed and not. Former industry executive, Hunter Harrison, is widely credited for the advent of PSR. Many of his proteges are still leading or advising other railroad firms. Some of those executives have had a big influence in making select companies more profitable.

Kansas City Southern is in the process of merging with Canadian Pacific. Can you update us on that transaction and offer any thoughts on further M&A?

Tim Porter: We think it’s likely the deal gets approved, but we don’t expect further consolidation due in large part to antitrust concerns. Some of these railroad networks now connect three different countries, so any additional mergers would represent a significant geographic footprint that could draw anti-competitive concerns from regulators.

Reaves published a prior blog about improving operating ratios. Is there more room for improvement?

Tim Porter: Yes. While PSR has already improved operating ratios there is still potential for improved logistics technology to help create longer train links, which makes transportation more fuel efficient. The industry could still reduce dwell times at rail yards. Finally, technology is allowing for automated track and car inspections. Eventually, we could see technology improvements make trains operable with only one engineer versus the required two engineers per train now.

The Case for Essential Service Infrastructure

Disclosures and Definitions:
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.

1Railroad stocks are represented by the following securities: Kansas City Southern, Norfolk Southern Corp., CSX Corp., Union Pacific Corp, Canadian National Railway, and Canadian Pacific.

2Source: Bloomberg, Feb. 18, 2011 to Feb. 4, 2022

As of Reaves’ most recently filed 13F dated 12/31/21, some of Reaves’ managed portfolios owned Norfolk Southern Corp., Union Pacific Corp, and Canadian National Railway, Canadian Pacific, and none of Reaves’ managed portfolios owned CSX Corp. and Kansas City Southern.

The S&P 500 Index (“S&P 500”) is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The typical Reaves portfolio includes a significant percentage of assets that are also found in the S&P 500. However, Reaves’ portfolios are far less diversified, resulting in higher sector concentrations than found in the broad-based S&P 500.

Mergers and acquisitions (M&A) is a general term that describes the consolidation of companies or assets through various types of financial transactions, including mergers, acquisitions, consolidations, tender offers, purchase of assets, and management acquisitions.

Past results do not guarantee future performance. Further, the investment return and principal value of an investment will fluctuate; thus, investor’s equity, when liquidated, may be worth more or less than the original cost. This document provides only impersonal advice and/or statistical data and is not intended to meet objectives or suitability requirements of any specific individual or account.

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