Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.
This piece provides a brief discussion about the rail industry and how investors can seek to gain exposure to a theme that we only expect to grow in importance.
Many of us may wish that Periander of Corinth were still ruling Greece. In contrast to the country’s current dire situation, under his watch in the 7th and 6th Centuries BC, Greece enjoyed a golden age of unprecedented stability. Periander is also credited with adopting the phrase, “be farsighted with everything.” As the pioneer of the first form of railway, Periander’s perspicacity in this respect has reaped subsequent rewards.
From slaves pushing trucks in limestone grooves more than 2,500 years ago, the global rail network has evolved – via steam, electrification and dieselisation – now to comprise more than 1.3bn kilometres of track. Along the way, investors have both lost and made prodigious sums of money in rail, but with the industry now radically more efficient than ever before and underpinned by a series of structural secular drivers, we see the recent rail renaissance continuing for some time. Warren Buffet’s $34.4bn purchase of Burlington Northern Santa Fe in 2009 (his largest ever) would also seem to provide particular endorsement for the theme.
Population growth, the industrialisation and urbanisation of the emerging world, and an expansion in global trade flows imply that both more people and goods will need to be transported over time. When grappling with this dynamic, central planners as well as both individuals and companies are deeply conscious not only of the relative cost of competing transport mechanisms but are also increasingly aware of arguments relating both to diminishing conventional fuel sources and to climate change. Put simply, as will be demonstrated in more detail below, rail represents the most efficient way of dealing with these challenges.
There are more kilometres of track (225,000km) and billions of tonnes of freight (2,700bn) in the US than any other country globally and so much of the following discussion will relate specifically to the American market although the arguments have substantial validity globally. This is particularly the case since policy-makers in India, China, the Middle East and Eastern Europe are increasingly allocating public funding to rail development and renewal over other competing transport mechanisms. For America alone, the volume of rail freight transport is expected to double over the next 30 years according to Rand, a US consultancy. The Rail Freight Group, an industry consortium, forecasts similar freight growth for Europe in this timeframe. Meanwhile, SCI-Verkehr (a German consultancy) predicts an expansion in global passenger volumes of 3-5% p.a. through until 2020.
In a piece of legislation worthy of the foresight of Periander, the 1980 Staggers Rail Act served as the catalyst for galvanising the US rail industry. With the aid of deregulation, the industry consolidated substantially, from 41 major operators to the current 7. According to the Department of Transportation (DoT), in the 15 years following deregulation, track kilometres were reduced by 40% and freight cars by 30% (with employment also halved), resulting in a notably more efficient industry with lower operating costs. The cost arguments helped drive demand and subsequent capacity constraints permitted the rail operators to push for better pricing, creating a virtuous circle effect of which many (including Buffett) began to take note.
At the heart of the case for rail is that the network has substantial economies of scale; it is capable of high levels of capacity utilisation. Speed and reliability are also compelling supporting factors. Tracks provide smooth and hard surfaces on which train wheels can run with minimum friction; metal wheels on metal rails have a major advantage in overcoming resistance when compared to rubber-tied wheels on any road surface. The metric of tonne-miles per day is used to capture cargo capacity combined with speed and size. According to the American Railway Engineering and Maintenance Association, a long-haul train is able to carry 500,000 tonne-miles per day, 25 times more than a full utility truck.
Greater efficiency also means lower costs. The DoT calculates that operating costs (measured by per tonne per mile) and locomotion costs (defined on a per container per mile basis) are between four and five times more expensive for truck relative to rail. In a world of diminishing energy resources, rail makes sense. The ‘peak oil’ argument is well-understood and on the DoT’s analysis, for every 100 miles travelled, trains consume 19 gallons of fuel, compared with 57 gallons for a truck, making them three times more efficient.
If rail were not already both cheaper and more efficient than road as a form of transportation, then three other factors support further the relative case for rail. First, growing highway congestion is an issue that rail freight operators simply do not face. A 2007 study by a group of US academics suggests that road congestion resulted in over 8bn litres of wasted fuel and more than 4bn hours of lost time for American highway users. This figure is likely only to have risen since then and also does not take into account the ‘public’ costs attached to congestion of higher levels of accidents, pollution and noise. Trucks emit around three times more nitrogen oxide and other noxious substances than a rail locomotive, based on data from the US Environmental Protection Agency.
On the topic of safety, more figures from the DoT suggest that rail is an overwhelmingly less dangerous form of transport than any other. Travelling by road is 8 times more dangerous than travelling by air and 27 times riskier than using the train as measured by the number of fatalities per every 100 passenger miles travelled. Similar analysis in Europe (by the European Commission) suggests that rail travel is around 16 times safer than either road or air. The third factor conspiring against road transportation is the growing number of truck driver shortages, a function of retirements, lay-offs in the last recession and tougher regulation (in particular relating to the number of hours worked without a break and to drink-driving). The US Council of Supply Chain Management estimates that some 150,000 truckers have been laid-off since 2008.
Looking forward, there is also scope for rail operators to make additional efficiency gains, widening further the gap between it and other competing transport alternatives. The standardisation of transportation container size (the International Organisation of Standardisation first passed legislation to this end in 1968) allows for rail operators not only to benefit from growing inter-modal transportation trends, but also to manage their yields more effectively. In other words, operators in the US (and elsewhere) have adopted many practices familiar from other industries (for example, among airlines), implementing policies such as running longer trains at faster speeds, improving their scheduling, reducing dwell time at switching hubs, optimising their rolling stock and even adopting auction pricing to balance transport over the week. Double-stack cargo transporters have been in use for some time, but are also growing in popularity. One of these trains is able to carry the equivalent load of 280 road trucks.
Despite these potentially persuasive arguments, rail still has its detractors. With the global (and in particular, the US) economy looking increasingly lacklustre, some of the drawbacks in the business model may become more evident. When cyclically driven transport levels are considered (more coal and agricultural goods are transported than any other commodities), rail is both less flexible and more capital intensive than road. On a related point, transport volumes of many commodities carried may also be highly dependent on seasonal factors. In addition, railroads bear the full cost of building and maintaining their infrastructure (in contrast, highway infrastructure costs are charged indirectly to users through motor vehicle taxes), and a large fraction of this cost remains independent of traffic volumes.
From an investment perspective, other concerns that are raised about rail relate to relatively higher levels of industry intervention, either by regulation or by the influence of trade unions given the substantial unionisation of the workforce and the collective bargaining agreements they have often sought to strike. Nonetheless, these negative considerations should be considered as short-term, more cyclical factors rather than the structural factors detailed above that lend support to the ongoing industry case.
As Buffett would inevitably have been conscious of, there are very few ways for investors to gain direct exposure to the rail theme. Indeed, the value attached to scarcity only increases the relative attractiveness of rail. Several private equity investors have also been cognisant of this dynamic and have been active within the rail space, particularly with regard to leasing railcars in particular. Railcar leasing offers exposure to the generic growth opportunity within the sector and has a low-risk profile, being inflation-hedged and recession-tested while providing durable income streams. More than 50% of railcars in the US are leased.
Part of the reason for focusing primarily on the US industry is that in many other countries (in Europe and Asia), rail operations remain the preserve of the government and so are not publicly listed. Even in the UK, where the Thatcher administration followed the initiative of Staggers, the quoted transport companies (for example, Arriva, First Group) give investors exposure not just to rail but also to the less attractive bus and coach markets. Moreover, these businesses are much more passenger- than freight-centric and so are inherently more cyclical. Companies that are involved in the construction of rail networks, peripheral equipment (like signalling) and/or carriages such as GE, Siemens or Invensys also offer an alternative means for exploiting this theme, but rail is typically just one relatively small element of these companies’ business.
Returning to the US, as mentioned previously, consolidation has resulted in a highly concentrated industry and with the acquisition of Burlington Northern, there remain just six quoted rail companies. Our two preferred names within the universe are Kansas City Southern (KSU) and Canadian National Railway (CNR). The former looks to be the best-positioned railroad in the Americas, with over 6,000 miles of track spanning not only the US, but also Mexico and Panama. As such, KSU is poised to benefit from increased cross-border traffic, particularly given the generic growth prospects for the Mexican economy (augmented by an increasing number of US companies setting up low cost operations there) as well as the development of the Lázaro Cárdenas port hub. Consensus expectations forecast better growth prospects for KSU than any other listed railroad. Canadian National remains the industry benchmark, operating the most efficient and productive network in the Americas. Limited further investment is required in its business, implying scope for potential cash returns to investors going forward. The rail renaissance seems firmly to be upon us.
Alexander Gunz, Fund Manager, Heptagon Capital
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Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation. Executive Summary: Thematic investing is a core part of our investment process at Heptagon. Since 2011, we have published 50 dedicated pieces of thematic […]
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