This article was co-produced with Nicholas Ward.
Roughly a year ago, as a part of the Monopoly Man series we published at iREIT on Alpha – which focused on the highest-quality stocks and best values we saw in each subsector of REIT-dom – we put together a report on the railroad industry.
After all, you can’t talk about Monopoly without highlighting the railroads.
At the time, we acknowledged that they were trading with premium valuations. Yet we concluded that piece on a bullish note:
“With that in mind, if you’re looking to put cash to work outside of the REIT space… you may want to take a page out of Hasbro’s book and add a railroad or two to your watchlist.”
We also touched on the strong dividend growth that these stocks were likely to produce for investors, saying that:
“These stocks appear to be primed to generate strong returns over the next several years.”
So what’s happened since then?
Now, when we published that article, we admittedly underestimated how much macro supply chain disruptions there would be. The epic port backups we’ve witnessed along the West Coast over the last year have certainly hurt intermodal shipment volumes.
Even so, class 1 rails have largely continued to increase their efficiency numbers – and therefore higher cash flows too – even in the face of volume headwinds.
The fact of the matter is class 1 rails have incredibly wide moats. They aren’t building any more major rail lines in North America).
Over the years, we’ve seen this result in pricing power. And, moving forward, railways continue to be one of the most efficient and cost-effective ways to move goods and materials.
Therefore, over the long-term, we expect to see strong demand metrics across the industry.
These companies perform exceptionally well during periods of economic expansion. And we’ve seen the blue-chip examples in this space produce very strong fundamental growth during the trailing 12 months.
That’s led to several major players making strong double-digit dividend growth announcements in recent months.
Such moves naturally caught our attention. So we’re more than happy to provide an update on railroads and how they play into our general bullish thesis on hard assets and commodity prices as the economy continues to recover.
Of the railroads we’re discussing, Canadian National Railway (CNI) raised its dividend the most –from C$0.6150 to C$0.7325. That’s 19% year-over-year growth.
CEO JJ Ruest touched on this during CNI’s recent Q4 conference call, marking the company’s 26th consecutive yearly increase. That makes it a dividend aristocrat.
“The board also approved a new share buyback program for an amount in the range of C$5 billion from February 1, 2022 to January 31, 2023. Together, these actions demonstrate CN's commitment to a balanced capital allocation program that puts a priority on returning excess capital to shareholders.”
Shares are down on a year-to-date basis, but just slightly. As of today, they’re down 0.51% on a year-to-date basis… meaning they’ve outperformed the S&P 500, which is down roughly 7%.
Because CNI is a Canadian company, U.S. investors do have to deal with forex when collecting their dividends. Right now, the U.S. dollar is worth C$1.28.
So at Canadian National’s last-checked price of $122.47, its shares yield approximately 1.88%.
This clearly isn’t a high-yield company compared to many of the real estate investment trusts (REITs) we track. However, it’s well above the S&P 500’s 1.28% and essentially in-line with 10-year Treasury notes’ 1.91%.
Besides, CNI’s dividend presents with a wonderful dividend growth story.
It’s compounding at a rate well above the S&P 500’s, with an 11.35% five-year dividend growth rate. And over the last 10 years, we’ve seen CNI grow its payout from $0.66 to $2.30.
That represents a 10-year compound annual growth rate ('CAGR') of 13.3%.
We believe this railroad can continue to compound its dividend at a reliable double-digit rate. So this could be an attractive buy for pre-retirees with long-term time horizons or retirees with nest eggs large enough that an approximate 2% yield meets their passive income needs.
Canadian Nation Railway has overcome some recent weather-related issues as well as the macro supply chain crunch. That’s largely due to its ongoing focus on operational efficiency.
Its operating ratio improved by 4.2 basis points (bps) during 2021, helping its stock produce 12% adjusted earnings per share 2021 growth.
During 2021, management hit the top end of its free cash flow guidance, posting:
And management continues to be bullish on its operational prospects, recently updating its full-year 2022 guidance. Now it expects around 20% bottom-line growth, which matches Wall Street’s consensus of 19%.
With this in mind, CNI’s forward price-to-earnings (P/E) ratio is 22.77x. As you can see below, this is above its 21.75x five-year average.
The current valuation might appear high based on trailing data. But keep CNI’s double-digit growth forecast in mind, which could justify the premium.
Shares definitely aren’t trading with a wide margin of safety. Yet, assuming management can meet growth expectations over the next 3-5 years…
Buying CNI today should give investors the ability to compound their wealth at a mid- to high-single-digit clip.
This isn’t exciting, but owning blue chips rarely is. They’re about generating lasting wealth in the markets.
In short, Canadian National Railroad has done a wonderful job of reliably growing its top and bottom lines. Therefore, with shares down approximately 10% from their 52-week highs, we’re becoming more and more bullish.
Norfolk Southern’s (NSC) management team also provided investors with a strong dividend increase late in January. It raised its quarterly dividend from $1.09 to $1.24, representing 13.8% year-over-year growth.
Unlike CNI though, NSC isn’t a dividend aristocrat. It froze its dividend for a year during 2015-2016. So it only has a six-year track record.
Then again, it also didn’t cut its dividend in either of the last two economic recessions. And it’s clearly been steadily trending in the right direction for several years now.
Looking at Justin Law’s Dividend Champions List, we see that NSC has produced a five-year dividend growth rate of 12%. And its 10-year is 9.6%, including the aforementioned freeze. Which makes it all the more impressive.
Shares themselves are down roughly 7.35% on a year-to-date basis, so it’s hardly outperforming so far this year. But because they’re down nearly 10% from their 52-week highs, NSC’s dividend yield is up to the 1.83% area.
Once again, that’s higher than the S&P 500’s and the broader markets.
In terms of recent operational performance, we see very similar results from NSC as with CNI.
For one thing, Norfolk Southern reduced its operating ratio by 430 bps to an all-time record of 60.1% last year. It also posted 14% revenue growth during 2021 and 31% EPS growth during the TTM.
During 2021, operating income and net income were up 28% and 27%, respectively – strong bottom line results that keeps the double-digit dividend growth coming.
NSC is working hard to increase its trail size (length and weight), which greatly increases efficiency results. Management continues to make infrastructure investments to improve this trend.
We believe its disciplined focus on profit-related metrics will help it stay on its double-digit EPS growth trajectory from here.
Moving on to valuation, NSC shares were trading with a forward price-to-earnings ratio of 19.75x at last check.
This is well below their five-year average P/E ratio of 21.2x. So we believe they do present a better deal than CNI. Investors get the chance to generate significant returns in the near term this way.
As you can see on the chart below, assuming NSC can meet Wall Street’s expectations for earnings growth during the next two years…
And we see mean reversion back up to its five-year average P/E level…
Investors buying shares today could generate double-digit annualized returns during the next couple of years.
Combine these results with strong dividend growth expectations moving forward? And NSC appears to be a stock that can fit into a wide variety of portfolios.
During our original railroads article, we highlighted Union Pacific (UNP) as the best-of-breed pick. And shares haven’t disappointed since, posting total TTM returns of about 21%.
The company also announced mid-December that it was increasing its quarterly payment from $1.07 to $1.18.
This was its second 10.3% year-over-year dividend raise in 2021. UNP also increased it during the May quarter from $0.97 to $1.07.
As such, its most recent dividend was 21.6% higher than its quarterly payment one year before.
UNP is down 3.01% on a year-to-date basis, representing relative outperformance. Though, compared to CNI and NSC, these shares have helped up the best overall during the recent market volatility. They’re down only 4.99% from their 52-week highs.
Plus, they yield 1.94% at last check, the highest yield on this list.
UNP did freeze its dividend for a couple of years in the mid-2000s. So it’s “only” running on a 15-year increase streak.
However, over the long term, you’ll be hard pressed to find a company with more reliable double-digit annual dividend growth. Its five-year, 10-year, and 20-year dividend rates come in at 13.7%, 16.1%, and 17.1%, respectively.
In short, a stock with an approximate 2% yield that’s producing reliable 10%+ dividend growth is a great recipe for passive income success over the long term.
And, looking at UNP’s recent results and forward guidance, we believe it’s likely to stay on its strong trajectory.
UNP has the best operating ratio on this list, solidifying its best-in-breed status. At the end of its most recent quarter, its operating ratio was 57.2%.
As shown below, UNP’s full-year 2021 results have pushed its sales back up above its pre-pandemic 2019 figures. More importantly, it spent $7.3 billion buying back shares, allowing it to retire roughly 3.3% of its outstanding count.
This improved efficiency metrics, and UNP’s EPS are now 18.7% higher than its 2019 total. In short, this company’s 2021 results were fantastic.
Moving forward, UNP management expects to use its cash flows to buy back a similar amount of shares in 2022. Combined with increased volumes and ongoing efficiency gains, this should allow it to produce strong double-digit EPS growth once again.
Right now, consensus analyst estimates for 2022 EPS are for 16% bottom-line growth. And we see that, after its recent 5% pullback, these shares are trading for 21x forward earnings.
Looking at the chart above, you’ll see that UNP’s five-year average P/E ratio is 23.35x. Therefore, it appears to represent a bargain today, especially for longer-term shareholders.
Add all that to another 11.2% expected EPS growth in 2023, and shareholders buying UNP at today’s could be setting themselves up for double-digit annualized returns over the coming years.
At the end of the day, no, none of these stocks are exciting.
However, they all provide relatively low betas throughout the recent market volatility. And moving forward, we wouldn’t be surprised to see this continue because of the reliable cash flows that class 1 rails tend to generate.
Besides, we’re not going to knock defensive holdings during such uncertain market times. Relatively low volatility and increasing dividends go a long way toward providing investors with peace of mind.
We continue to believe this industry is well-suited to benefit from ongoing economic expansion – especially as supply chain issues resolve themselves. Therefore, looking ahead, we’re bullish on these stocks’ fundamental growth prospects.
Their recent double-digit dividend raises and S&P 500-beating yields are compelling, especially since they’re expected to continue. And while their yields stack up evenly against the U.S. 10-year bond…
They’re still superior since U.S. treasuries don’t post organic annual growth.
All told, we believe railroads continue to be a strong passive-income avenue to consider.
Author’s Note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: written and distributed only to assist in research while providing a forum for second-level thinking.
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This article was written by
Brad Thomas is the CEO of Wide Moat Research ("WMR"), a subscription-based publisher of financial information, serving over 6,000 investors around the world. WMR has a team of experienced multi-disciplined analysts covering all dividend categories, including REITs, MLPs, BDCs, and traditional C-Corps.
The WMR brands include: (1) The Intelligent REIT Investor (newsletter), (2) The Intelligent Dividend Investor (newsletter), (3) iREIT on Alpha (Seeking Alpha), and (4) The Dividend Kings (Seeking Alpha). Thomas is also the editor of The Forbes Real Estate Investor and the Property Chronicle North America.
Thomas has also been featured in Forbes Magazine, Kiplinger’s, US News & World Report, Money, NPR, Institutional Investor, GlobeStreet, CNN, Newsmax, and Fox. He is the #1 contributing analyst on Seeking Alpha in 2014, 2015, 2016, 2017, 2018, and 2019 (based on page views) and has over 102,000 followers (on Seeking Alpha). Thomas is also the author of The Intelligent REIT Investor Guide (Wiley).Thomas received a Bachelor of Science degree in Business/Economics from Presbyterian College and he is married with 5 wonderful kids. He has over 30 years of real estate investing experience and is one of the most prolific writers on Seeking Alpha (2,800+ articles since 2010). To learn more about Brad visit HERE.
Disclosure: I/we have a beneficial long position in the shares of UNP either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.