Investing in railroads: Double digit returns since 1995?

When discussing stocks at parties, everyone likes to talk about hot companies that are in the news. Tesla, Netflix, Amazon and others. The annoying ones don’t stop talking about Bitcoin. I have yet to have someone come up to me and say “I like railroad stocks like Canadian National Railway. Boring, safe way to earn double digit returns year after year.” I will discuss this later in the article but first you need to know the history of railroads in North America.

The railroad was first developed in the early 1800’s in Great Britain by a man named George Stephenson. George never went to school, but at 18 he taught himself to read, write and basic arithmetic. Gifted with an engineering mind he successfully applied the steam technology of the day and created the world's first successful locomotive. George at the time had no idea just how his invention was going to change the world.

“The railroad was a new technology, an industrial version of the Internet requiring continuous innovation. Railroads spurred extraordinary feats of engineering. Nature had to be resculptured; tunnels had to be dug and bridges mounted over precipices. The transcontinental required an 800-foot-long, 63-foot-deep cut through a pass in the Sierra Nevada; it was blasted through at the pace of a foot a day. The tracks also passed along the edges of the rocky walls of a cliff 2,500 feet above a ravine.”

• Looking at the Transcontinental Railroad as the Internet of 1869, Edward Rothstein

Like the internet, railways forged previously unthinkable connections and opened up new opportunities for commerce. Railroads became popular because they dropped the cost of shipping by carriage by 60-70%. This makes sense imagine trying to ship lumber across the country by horse and carriage. It was expensive and time consuming. Commodities like grain, lumber, oil and coal could be shipped in days instead of weeks. In some cases hours instead of days. This explains how the North American economy rapidly expanded with the introduction of railroads.

Shipping and railroad tycoon Cornelius "Commodore" Vanderbilt (1794-1877) left school at the age of 11. When Vanderbilt started there were no railroads. He made his fortune in the steamship industry but in the 1860s, he shifted his focus to the railroads.

Vanderbilt provided the first rail service between New York and Chicago. His company revolutionized rail operations by standardizing procedures and timetables, increasing efficiency and decreasing travel and shipment times.

In the mid 1800’s, the US population was moving west and train service was the ideal mode of transportation. It was cheaper and quicker then alternatives available at the time. Vanderbilt took advantage of the situation and made a fortune. When Vanderbilt died, railroads had become the greatest force in modern industry, and Vanderbilt was the richest man in Europe or America, and the largest owner of railroads in the world. His net worth would have been more than $200 billion in today’s dollars.

"Any fool can make a fortune; It takes a man of brains to hold onto it after it is made." –Cornelius Vanderbilt

The irony is the Vanderbilt family were terrible at managing money and within just 50 years of Cornelius’s death, the Vanderbilt family fortune was completely gone. The Vanderbilts are best remembered for displaying their extravagant wealth by erecting opulent mansions (10 from what I found online) on Manhattan’s Fifth Avenue and throwing fancy parties on a regular basis that would put the Great Gatsby to shame. They were more interested in spending than investing and growing their net worth. The Great Depression hit in the 1930’s and eventually most of the money was gone.

Most ultra wealthy families live by the financial advice “Save the principal, spend the interest.” Looks like the Vanderbilts never followed that advice and paid a heavy price for it, literally. They should have kept their railroad stocks and lived off the dividends.

In Canada, railroad stocks such as Canadian National (CN) Railway and Canadian Pacific (CP) Railway Limited. have been fantastic investments over the past 20+ years.

As per their website, “CN Rail stock has increased at a compound annual growth rate of 16% since our initial public offering in 1995.” Incredible, yet nobody talks about this. Not even investment professionals. Annual double digit returns for 26 years is a fantastic investment yet nobody pays attention.

CN Rail share price was around $11 in 2003 and today it’s around $138 a share.

The quarterly dividend was $0.08 a share back in 2003. It’s $.62 a share now. Annualised high double digit capital and dividend growth. Most people get annual pay raises in the 2% to 3% range and banks pay less than 1% for money left in savings accounts.

Canada has a rail duopoly: where two firms have dominant or exclusive control over a market. CN and CP are the only options for companies to ship products via rail. It is impossible for a billionaire or another company to come in and set up a railway. Good luck trying to lay track in one city let alone a country like Canada. It’s not just the billions it would require in start up costs but just trying to get all the legal, government and environmental approvals makes it an impossible task. Nobody wants a rail line in their backyard especially after a runaway train carrying crude oil derailed and exploded in 2013 in Lac-Megantic, Quebec, killing forty-seven people. It made national headlines. Look how hard it is to build pipelines in North America.

According to Howard Green’s book Railroader (Best book on the rail industry), the construction of CP railroad had been financed and backed by the federal government. CP received 25 million acres of government land. 600 Chinese workers (official count and could be higher) died constructing the railway in Canada and Indigenous communities ceded control of land. I don’t think anyone followed any strict environmental regulations when they blew up mountains in the Western Canada to lay rail tracks.

“They ain’t buildin’ any more railroads. Critical infrastructure was constructed decades, if not more than a century ago, as cities built up around rail lines. The only way for existing railroads to get bigger and more efficient was to swallow others.”

• Hunter Harrison from the book Railroader. Hunter was a famous and respected CEO who turned around four struggling North American railroads including CN Rail and CP.

This is important. Bill Gates (Microsoft) and Warren Buffett’s (Berkshire Hathaway) combined net worth is over $200 billion US. They are some of the wealthiest people on the planet. These two working together will not be able to build a new railway for all the reasons listed above and they know this. That is why Berkshire Hathaway paid $26 billion for Burlington Northern Santa Fe (BNSF) back in 2009. BNSF operates one of the largest freight railroad networks in North America, with more than 52,000 km of rail across the United States. Bill Gates owns more than 14% of all CN Rail shares making him the largest shareholder. Clearly there is the reason these two are consistently rated in the top 5 richest people in the world.

Before taking a deep dive into CN Rail I would like to discuss CP first. CP Rail was built more than 135 years ago and is a major transporter of bulk commodities across the nation. CP Rail network stretches from Vancouver to Montreal, and the company also has a presence in the north-central United States. All together, Canadian Pacific operates just over 20,000 km of rail. Check out the map below:

CN Rail has been our favourite of the two. It’s been a fantastic rail operator that it’s been deemed North America’s most efficient railway. It was owned by the Government of Canada until 1995, when it became a public company and anyone could buy shares. CN Rail’s market capitalization was just over $2 billion then. It’s $98 billion now.

Their moat, a distinct advantage a company has over its competitors which allows it to protect its market share and profitability, literally spans 30,000 km of tracks across Canada and Central America starting from the Atlantic and Pacific oceans to the Gulf of Mexico. CN Rail is the only railroad on the continent with access to all the three coastlines ranging from the U.S. Midwest to the Gulf Coast region, giving it a competitive advantage over its peers. Hundreds of billions of dollars in goods moved between the US and Canada. Check out their rail map.

Canada’s rail network is the economy. Rail stocks do well when the economy is expanding and growing. Warren Buffet explained his purchase of Burlington Northern during the 2009 recession, "I just basically believe this country will prosper, and you'll have more people moving more goods 10 and 20 and 30 years from now, and the rails should benefit." So far he has been right. Consumption continues to increase as people keep buying more stuff.

CN Rail transports over $250 billion worth of freight every year comprising automotive components, chemicals, crude oil, and wheat, and so on. 95 percent of grain exports in Canada travel by rail. One car of grain can be worth as much as $30,000. Next time you see a train go, count the rail cars. If they are transporting oil, lumber or other commodities the value of each car jumps higher. A railroad is often viewed as a recession proof business.

Hunter Harrison said, “Railroads only make money when cars are moving. Track is a railroad’s most expensive physical asset.” Railroads have been getting significantly better at controlling their expenses by shedding tracks, leaner labour forces and longer/heavier trains. All this leads to better operating ratios and more profits. The railroads main competitor is the trucking industry.

In 2019, CN Rail had revenues of $14.9 billion and net income of $4.2 billion. It’s operating ratio (OR) was 62.5%. The key measure of railroad performance. Every time a railroad releases its quarterly numbers investors want to know if the OR is increasing or decreasing. It shows how efficient a company's management is at keeping costs low while generating sales. The smaller the ratio, the more efficient the company.

In railroading, an OR of 80 or lower is considered desirable. If it’s in the high 90s it means the railroad has spent everything it generated in sales. Not a good place for any business to be.

For every $1 in sales CN Rail generates $.375 in profit (before interest, taxes, depreciation and amortization).

Have a look at CN Rail stock chart:

Anyone played Monopoly? In the game of Monopoly, The rent for railroads depends on how many railroads the player owns. If you own one, the rent on it is $25. If you own two, you get $50 rent from anyone landing on either, if you own three then you get $100, and if you own all four railroads then the rent is $200. Nobody ever got rich owning railroad stocks in Monopoly; you can’t build houses or hotels on them. However, most people don’t realise that railroads are highly lucrative investments in real life.