The Canadian railways are part of an exclusive club in Canada. According to Morningstar Canada there are only five Canadian-wide “moat” stocks. The list is short: RBC, TD, Enbridge, and then our two Canadian railway dividend all-stars: Canadian Pacific Railway (CP) and Canadian National Railway (CNR).
When a company is described as having a “moat,” that means it has a protective barrier, just as a moat around a castle would provide protection from invaders. A moat means a company has limited or virtually no competition. You don’t need to be Warren Buffett to figure out that no competition is good for long-term business!
This is very similar to the big Canadian banks which i covered last month. You can read that article and compare their performance, so you can determine which one is a better investment.
When you invest in the Canadian railways you gain access to companies that have a lock on the transportation of goods across the country. They also move goods to and from the US. That’s a valuable and dependable business to be in.
You’ll find many of those Canadian moat stocks including CN Rail in my list of Top Canadian Dividend Growth Stocks for 2021.
While having a lock on a sector is an obvious benefit and it removes the risk of competition, it is no guarantee of investment success. There can be periods of weakness. The railways are economically sensitive companies. When the economy slows, less goods are moved around the country. In a recession, rail traffic can be greatly impaired.
For example, in the not-too-distant past, the rails were moving a lot of oil, but those volumes have dropped due to the pandemic. Much of that oil supply has moved back to the pipelines. So if you also hold some of the major pipelines in Canada you’ll be picking up that business by way of those holdings.
That said, the Canadian rail stocks are perpetual stock market beaters. Here are the rails vs the TSX 60 (XIU) from January of 2002.
We can see from the Year to Date (YTD) and 1-year numbers that the rails have been a wonderful portfolio diversifier to hold in the pandemic period and during the 2020 stock market correction. The rails have been some of the best large cap performers in the Canadian market.
Performance in the Pandemic
Canada’s two big railways reported quarterly profits in early October and the results were slightly below analysts’ expectations. The selloff that followed suggests that high stock prices and lofty valuations could be challenging in the months ahead.
From a recent Globe and Mail article:
“The shares of Canadian Pacific Railway Ltd. and Canadian National Railway Co. had been on a tear since March, rising to record highs as recently as last week. But the gains raised their respective price-to-earnings ratios to puzzling levels that were well above their long-term averages.
CP’s share price hit a record high of $429.75 last week, prior to the company’s earnings release. That’s up 60 per cent from the stock’s recent low in March and, perhaps more impressive, nearly 20 per cent above its pre-pandemic high in February, before the lockdown and arrival of the economic downturn.”
“CN shares have been on a similar trajectory. They hit a record high of $147.42 last week, up 48 per cent since March and more than 17 per cent above their pre-pandemic high.
CN’s price-to-earnings ratio, based on estimated profits, surged to 23, according to Raymond James. That’s well above the average P/E of 17.6 over the past five years – a period during which the ratio never rose above 20.
CP shares recently traded at 21.5-times estimated profits, also well above the five-year average of 16.3. Previously, the P/E ratio hadn’t cracked 19.”
Here is a look at the historical P/E ratio to November 4, 2020 for the rails courtesy of Dividend Stocks Rock.
The Canadian railways are pricey, but that might be expected given the wide moat oligopoly status. But the good news is, there’s still growth potential.
There’s Growth Coming Down the Track
Though railways aren’t laying down many new tracks, they are expanding with new infrastructure and customer relationships that are adding new revenue streams.
CP has a new deal with container shipping company AP Moller-Maersk to move cargo from the ports of Vancouver and Montreal. CP is also buying full control of the Detroit River Tunnel, which connects Windsor with Detroit.
The pandemic has moved railways to get leaner and meaner. Railways have been getting significantly better at controlling their expenses by shedding tracks and through leaner labour forces. Operating ratios have fallen below 60% (low is good) from about 90% in the mid-1990s.
It’s expected that CP’s earnings per share in 2021 will increase 13.5% above the railway’s 2020 profit. For CN, the Raymond James analyst expects earnings to increase about 22% in 2021.
From a Scotia research note, and commentary on their latest quarterly results.
“Canadian Pacific Railway Limited Stronger Q4 Outlook More than Offsets Q3 Miss OUR TAKE: Slight Positive. We are not surprised by the stock’s ~1% pullback yesterday given it had a good run (+16% since prior earnings) heading into the Q3 print and CP missed Street’s bullish OR expectation. While Q3 also slightly missed our estimates, we came away more positive on core 2020 EPS outlook and confident in our 2021-22 forecasts. CP raised 2020 guidance, painted a bullish OR picture, and announced another intermodal contract. We maintain our C$450 target.”
The 2021 outlook from Scotia.
“… we expect that double-digit EPS growth could be achievable next year, assuming the economy continues to recover from COVID-19. U.S. election.”
CP Rail Results and Outlook
Again from Scotia …
“Noisy Q3/20, Growth & FCF Story Intact OUR TAKE: Slight Negative. CNR reported a Q3 miss after close yesterday, which could negatively impact the stock given it had a good run (+13% since prior earnings) heading into the print. The quarter was quite noisy due to several mix and OR issues (partly related to COVID-19). While some noise continues in Q4 and FX is turning slightly less favourable (CAD strength), our estimates are broadly intact as traffic is recovering faster than expected and future growth drivers remain intact. We would take advantage of weakness as CNR delivers strong EPS and FCF growth, lapping easy comps over the next four quarters. We maintain our SO rating and C$152 target.”
And from Scotia on the outlook for 2021 …
“Although we expect formal guidance in January, mgmt comments suggest to us that double-digit EPS growth could be achievable next year … assuming the economy continues to recover from COVID-19.”
Recent Investing Recommendations
Canadian Pacific recently made a “top 30 stocks” from a US bank, Wells Fargo. It was the only Canadian stock to make the list
The Net Takeaway?
The Canadian railway stocks are obviously wonderful long term dividend investments. They consistently increase revenues, profits, and dividends over time. And while the dividends are modest in yield at the moment, these are great companies that add total return potential and very effective diversification for the total portfolio.
Canadian National Railway has a current yield of 1.7%.
Canadian Pacific Railway has a current yield of 0.6%.
Once again, these are total return plays.
Start a Position, Add on Weakness
I’ve never been a fan of waiting for a stock to drop in price. That drop may not come and you eventually lose interest in a stock, thinking you missed your chance. If you like the idea of the Canadian rail stocks you might start a position, and then add on any weakness. Or you may decide to start that position and add to it on a regular schedule. Take the market timing guesswork out of the picture.
Wide moat investing is my strategy for Canadians dividend stocks. I’m determined not to be the one that misses my train!
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