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The Surprising Reason Why Railroad Stocks Doubled the Market in the Last 5 Years

By Lee Samaha - Jan 26, 2021 at 8:17AM

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Sometimes investing in a boring sector can be fun after all.

You don't always need to invest in hot technologies or glamorous business sectors in order to generate market busting returns. That's a fact that investors in the railroad industry will be more than happy to attest to. And they can, because the average share price growth of Union Pacific (UNP -3.63%), CSX (CSX -4.47%), Norfolk Southern (NSC -2.43%), and Kansas City Southern has more than doubled the gains of the S&P 500 index over the last five years. Let's take a look at why, and what investors can expect in the future from the sector.

Railroads are rolling

The major development in this industry over the last few years has been the wide-scale adoption of what's known as precision scheduled railroading (PSR) management techniques. In a nutshell, they are initiatives designed to allow the companies to move the same amount of carloads using fewer assets.

A freight train.

Image source: Getty Images.

At the heart of PSR is a commitment to running routes at fixed times, between fixed points on a network. This may sound simple, but it's actually a significant departure from the traditional hub-and-spoke model that railroads used. For example, under the PSR model, pricing is adjusted in order to ensure profitability on a route, but what's not flexible is the route itself.

With PSR, the name of the game is improving a host of metrics that all add up to reducing a railroad's operating expenses. Examples increasing freight car velocity, reducing freight car terminal dwell, increasing trip plan compliance (i.e., delivering railcars on time), increasing train length, and generally improving locomotive and workforce productivity. As a consequence, railroads are able to reduce their workforce, close unnecessary hubs, and operate with relatively fewer locomotives.

More profits, more value

It all adds up to reducing something called the operating ratio (OR). This is calculated by simply dividing operating expenses by revenue. It's a key metric used by the railroads and they all report it as a matter of course. Obviously, a lower OR means a higher operating margin, because operating profit is calculated after expenses are taken out.

The bottom line is that the major listed U.S. railroads have all expanded their operating margins in the last few years.

KSU Operating Margin (TTM) Chart

Data by YCharts

For a flavor of how railroads have improved matters here's a look at the improvements in PSR metrics and OR for Union Pacific in its latest quarter.

Union Pacific

Q4 2020 Compared to Q4 2019

Freight car velocity

6% improvement

Average terminal dwell

8% improvement

Locomotive productivity

14% improvement

Train length

14% improvement

Adjusted operating ratio

58.5% in 2020 vs. 60.6% in 2019

Data source: Company presentations

Why it matters

At this point, you might be wondering how a few points of operating margin improvement -- during a period when revenue growth has been weak -- leads to such a startling improvement in share prices? The answer is that managements, and the market, view those margin improvements as structural in nature, and see the companies as capable of making further progress in the future.

In other words, when you sit down and calculate the long-term value of a company, a small increase in margin assumptions translates into a huge increase in long-term earnings expectations.

What's next for the sector?

Having performed admirably on OR during the pandemic-hit year of 2020, railroad companies have demonstrated that PSR improvements are here to stay and could lead to additional margin improvements. That said, it's hard to argue that the PSR secret isn't out yet. The market appears to have priced in a lot of positive assumptions for the railroads.

For example, the railroads' enterprise value (EV) to earnings before interest, taxation, depreciation, and amortization (EBITDA) multiples are at multiyear highs. Focusing on Union Pacific, Norfolk Southern, and CSX -- Kansas City Southern has its own trading dynamics relating to running routes to and from Mexico -- you can see that a lot of the good news has already been priced in.

CSX EV to EBITDA Chart

Data by YCharts

In this context, it's probably best to think of these stocks as relatively safe dividend plays that are worth holding as long as interest rates remain low and make their payouts relatively attractive.

CSX Dividend Yield Chart

Data by YCharts

As such, the boring sector that crushed the market in the last five years looks like it's going to become boring again. However, that shouldn't bother income investors too much.

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Stocks Mentioned

CSX Corporation Stock Quote
CSX Corporation
CSX
$30.88 (-4.47%) $-1.45
Union Pacific Corporation Stock Quote
Union Pacific Corporation
UNP
$216.83 (-3.63%) $-8.16
Norfolk Southern Corporation Stock Quote
Norfolk Southern Corporation
NSC
$231.79 (-2.43%) $-5.78
Kansas City Southern Stock Quote
Kansas City Southern
KSU

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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