Canadian National Railway's Fuel-Efficient Trains are Essential for Growing Global Trade
Jeff Wilson, CFA
Railroads evoke a bygone era of civilized travel. But they’re also an essential part of a sustainable transportation future. Moving goods by rail is significantly more energy efficient than using trucks—and it costs less. As companies look to make good on their environmental, social, and governance (ESG) commitments, many are looking at how to reduce their carbon footprints throughout their supply chain. Rail gives them a way to do that.
Knowing the key role railways play in the North American economy, Jensen analyst Jeff Wilson proposed looking at shares of Canadian National Railway (CNR) shortly after arriving in 2019. Wilson had previously researched the rail industry and grew excited when the company passed Jensen’s quantitative screening process.
“I had to help everyone else understand why this was a quality business and why we should spend the time researching it,” Wilson says.
Defending against competitors
Canadian National Railway, the fourth-largest freight carrier in North America, operates an advantaged T-shaped network with 18,600 miles of rail that spans coast-to-coast in Canada and extends south to the Gulf Coast of the United States through the heart of the U.S. Midwest.
“The rail map is pretty much set,” Wilson explains. “It would be very hard for anyone else to acquire the land and property rights that would be necessary to have a contiguous rail.”
As a result, Canadian National Railway has extremely high barriers to entry and switching costs that help it maintain its dominant position. For instance, the railway has exclusive rail access to the Port of Prince Rupert in Northwest Canada, which receives goods from Southeast Asia as the fastest route destined for Chicago.
Trucker shortages, combined with high oil prices, makes trains more competitive than ever, says Wilson. Trains can move one ton of freight for 480 miles on one gallon of diesel, which is three to four times more fuel efficient than trucks. The average cost to ship freight is 15.6 cents per ton-mile by truck, but just 5.1 cents by rail.1
“They are providing an essential service for the global economy in a fuel-efficient way,” Wilson says.
Making the case
But before Canadian National Railway could be added to the portfolio, Wilson first had to get buy-in from the rest of the Global Quality Growth Investment Team.
In order to be considered for inclusion in the strategy, stocks must pass a grueling vetting process. The investment team, consisting of both portfolio managers and analysts, starts by screening for quality first. At Jensen, that means companies must have returns on equity of at least 15 percent for each of the last 10 years as determined by the investment team. From there, the investment process winnows down the investable universe to just a few hundred names. With that list in hand, the team picks which names they want to research more.
Once the team members do their research, they write up 40- to 60-page reports on each of the companies they’re following for discussion at investment team meetings. Those meetings can be intense, with team members grilling each other with tough questions, often sending analysts and portfolio managers back to do more research. Only if there’s consensus among the investment team can a stock be considered for the portfolio.
“The consensus approach gives us varying viewpoints that challenge underlying assumptions and help ensure that we’re looking at all sides of the investments,” Wilson says.
Enviable cash flows
Among the concerns raised during these discussions was Canadian National Railway’s unusually high capital expenditures in 2018 and 2019. As a result, its free cash flow declined during that time, which could be a sign of business deterioration.
Wilson saw it differently: “They had capital expenditures well in excess of their history, which added much-needed network capacity to support future demand growth,” he says.
Once that investment period ended, Canadian National Railway resumed its robust free cash flow generation. “For every dollar of sales it generates, it earns over 20 cents of free cash flow in excess of the capital it spends to maintain its network,” Wilson says. “That free cash flow can be distributed to shareholders in the form of share buybacks or dividends.” Canadian National Railway has done both.
It also gives Canadian National Railway ample reserves to reinvest in the business and make ongoing network improvements that are expected to put the company in a better competitive position. Why does the Jensen investment team believe this? Collaborative research, of course.
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