In a private speech to the Financial Planning Association, legendary Vanguard founder and former CEO John Bogle made an absolutely critical observation about where the best stock returns come from -- and how to find the next great stock to buy.
He told the assembled guests that only three things drive investor returns:
- Dividends
- Earnings growth
- Changes in valuation
Historically, stocks have returned 9.6% per year on average -- 5%, 4.5%, and 0.1% from dividends, earnings growth, and valuation changes, respectively. Naturally, the best stocks produce the highest combined return.
So which rail stocks will earn investors the best returns today? Obviously, no one knows for sure. You should always take future estimates with a grain of salt, particularly when analyst forecasts are involved. In fact, studies show that analysts' long-term earnings-per-share estimates tend to be overoptimistic by roughly 40%, so I've reduced their estimates accordingly.
But investing is all about making predictions based on imperfect knowledge of the future. So long as we're aware of the need to think critically about a company's prospects and to build a margin of safety into our stock purchases, analyst estimates can be a helpful tool for generating ideas. By running the numbers, we can round up the stocks that represent their implied best buys today. Here are our assumptions:
|
Company |
Dividend Yield (current) |
5-Year Growth Rate Estimate (reduced by 40%) |
Implied Price-to-Earnings Ratio (in 2016) |
|---|---|---|---|
|
Norfolk Southern |
2.7% |
9% |
17 |
|
Union Pacific |
2.2% |
9% |
18 |
|
CSX |
2.5% |
8% |
16 |
|
RailAmerica |
0% |
10% |
18 |
|
Canadian National Railway Company |
1.9% |
7% |
15 |
|
Canadian Pacific Railway |
2.3% |
8% |
16 |
|
Genesee & Wyoming |
0% |
10% |
19 |
Source: Capital IQ, a division of Standard & Poor's. Includes stocks on major U.S. exchanges capitalized at more than $200 million, with positive earnings and at least one analyst issuing long-term earnings estimates.
And here are their implied five-year annualized returns for shareholders. I've ordered the three return components by their reliability -- first dividends, then earnings growth, then valuation.
|
Company |
Dividend Return* |
Earnings Growth Return |
Valuation Return |
Implied Cumulative Annual Return |
|---|---|---|---|---|
|
Norfolk Southern |
3% |
9% |
5% |
16% |
|
Union Pacific |
3% |
9% |
5% |
16% |
|
CSX |
3% |
8% |
5% |
16% |
|
RailAmerica |
0% |
10% |
1% |
11% |
|
Canadian National Railway Company |
2% |
7% |
2% |
11% |
|
Canadian Pacific Railway |
3% |
8% |
1% |
11% |
|
Genesee & Wyoming |
0% |
10% |
(2%) |
8% |
Source: Author's calculations. *Assumes dividend growth at rate of earnings growth.
The raw numbers tell us that these are the seven most promising names in rail. Of course, analysts' growth assumptions for any individual company could prove overly optimistic or pessimistic, as could their future valuations, so the implied cumulative returns are hypothetical. That said, this list helps you focus on this sector's highest potential returners -- and provides an excellent starting point of names for further research.
Don't stop here. If any of these stocks interest you, add them to your personalized stock watchlist to find out more about them. If you haven't started a watchlist yet, click here to begin.
