Consider investing in railroads

Railroads have driven both Canadian and American economic growth for centuries. And the perfect storm of economic activity, new oil reserves and environmental concerns has recently pushed these steady, yet stodgy companies to the investing forefront.

The discovery of shale oil has caused an oil boom in the U.S. That means American crude exports, primarily to eastern Canada, are soaring, as U.S. producers have excess supply. Further, their maritime laws limit the ability to ship to their own east coast, so Canada has become the preferred market.

Read: Energy exports to fuel Canadian growth

And even though pipelines can transport crude less expensively than shipping or railroads can, environmental concerns and political considerations are delaying any pipeline construction. While this is getting sorted out (and history proves it’ll take awhile), plan B is railroads.

Here are some railroad companies we put through our investment analysis process.

Canadian National Railway (CNR)

In North America, 90% of all goods are transported by railroad at some point in their life cycle from manufacturing to the consumer. CNR stands out because it’s the only railroad with a coast-to-coast network, along with a direct line to the U.S Gulf Coast. The company owns 33,000 km of rail serving both Canada and the U.S., with more than 20 strategically located terminals. By any metric, it is a dominant company.

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There are big changes occurring in the transportation industry and while, traditionally, truckers have dominated container shipping, railroads are now taking more of that business. Also, railways are increasingly moving crude to markets. The Canadian Association of Petroleum Producers expects crude shipments to triple by 2016. Add in best in class efficiency, currency advantages, pricing power and an attractive dividend, and this is a company to hold for the long term.

We initially bought CNR on Sept 22, 2009 at $26.79 (adjusted for split). Today, it trades at $77.45, up 494% in the last five years—not including the steady, and growing, dividend.

American Railcar Industries, Inc. (ARII)

Governments have recently introduced higher standards when shipping crude, mandating the compulsory retirement or retrofitting of tens of thousands of existing DOT-111 tankers. These new regulations, coupled with the oil industry’s increased shipments means increasing demand for new tanker cars.

Read: Infrastructure: A wise investment

And someone has to build those tanker cars. With only a couple of dominant companies in this business, we favour ARII, a sleepy, century-old company that’s been cranking out cars. It’s suddenly in full production mode due to a spike in product demand. We especially like the firm’s focus on tanker and hopper railcars, railcar orders on book, increased demand created by regulatory change, mix of railcars for sale (which translates into more upfront revenue), and railcars for lease (which provides longer term revenue).

We initially bought ARII on January 24, 2014 at $48.60. It now trades at $70.43, up 476% in the last five years, not including dividends.

The Canadian Pacific Railway (CP)

This is a firm that’s done well in the past, but it’s not one we recommend going forward. While we like the industry and management, we don’t feel the company has the girth to compete.

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In fact, CP inadvertently confirmed this just recently, as the firm explored acquiring CSX Corporation, a U.S. railway about the same size as CP. Though that acquisition didn’t happen, CP obviously sees what we see, and are looking for ways to get bigger, given that organic rail line growth ended a century ago in North America. CP operates primarily in Canada, and doesn’t have the benefit of its own line running down to U.S. Gulf Coast. The maturity of North America’s railway industry creates a reality of hunt or be hunted; with CP’s smaller size, it could serve as prey for some U.S. firm looking to expand northward. This sounds potentially profitable, until you consider that the Canadian government probably wouldn’t allow the foreign takeover of a main player in this vital industry.

CP trades at $230.25 and has done well in recent years. Although it meets our main criteria, we don’t see it keeping pace with the others when you factor in its high P/E ratio (for the rail industry), and high current debt level—even before it considers acquisitions. So, stick with CNR and ARII.

Gentry Capital’s Un-Common Sense is based on the “Red Light/Green Light Indicators” of company dominance, sector growth and corporate pricing power. It also includes “Amber Light Indicators,” which, while not deal breakers on their own, all form part of our black box to make decisions.

The opinions expressed are those of the author and may not necessarily reflect those of Manulife Securities Incorporated. Manulife Securities Incorporated is a member of the Canadian Investor Protection Fund.