AMM Dividend Letter Issue 17: The Biggest Threat to Your Portfolio & Norfolk Southern (NSC)
This is from the AMM Dividend Letter released March 12, 2015. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.
Sometimes we come across an article that is difficult to improve upon. The article below by Josh Brown of The Reformed Broker is such an article. We share the majority of the article with you below and with full permission from Mr. Brown.
The “you” in article is not just you but us too. We are in this together. Even though we are professionals, we are still humans. We’re still subject to the same emotions and fears as everyone else. We need to constantly reaffirm ourselves of the thoughts below and stay focused on our process.
Your Portfolio Management Team
The Biggest Threat to Your Portfolio by Josh Brown
The biggest threat to your portfolio is you.
China is not threatening your portfolio, nor is the price of oil or the level of the Fed Funds rate. What’s threatening your portfolio is the way in which you may react to any of these items, plain and simple. Your emotions and the actions you take during times of increased volatility or drawdown will ultimately have more impact on your long-term returns than any exogenous thing that may come along.
Our reactions to market stress and volatility, in the aggregate, usually involve some combination of the following:
* Fleeing into the arms of a charlatan who purports to having predicted it
* Buying into Black Swan funds and protective products that cap all future upside and cost a fortune
* Obsessing over hedges after the fact
* Selling out with big (permanent) losses and sitting in cash
* Freezing 401(k) contributions or having retirement cash allocated to money market funds
* Excessive trading
* Planting a flag and being unwilling to publicly change our minds in the face of new evidence
* Throwing money at bizarre alternatives like coins, bars, bricks and bullion which have no proven ability to fund a retirement
* Conflating political views with investment expectations
Note that every one of these things is extremely detrimental to our financial health. In some cases, the damage could be irreversible. Nothing kills the long-term returns of a portfolio like throwing away the playbook in the heat of a market crisis.
Hulbert had made the point that no one will see the thing coming that derails the economy or the market next time around. It certainly won’t be something that’s on the front page of the newspaper each day like Greece or interest rates. I would add in that we still cannot pinpoint the events that have marked previous market tops even in hindsight.
What happened on the day in March of 2000 when the NASDAQ stopped going up? Nothing, it just did.
What was the proximate trigger for the crash of ’87? There wasn’t one.
Why did the stock market ignore the real estate bust for 18 months until one uneventful day at the end of 2007 when all of a sudden it stopped climbing and reversed? We don’t know to this day.
What happened during the week after Labor Day in September 1929 that put the top in on the stock market? Nothing of note besides a bearish speech by Roger Babson a thousand miles away that may or may not have been noticed by traders on the floor.
If we cannot even identify the reason for why a market tops or crashes on a given day with the benefit of looking back, what makes any of us think we can do so in real-time or in advance?
More importantly, doesn’t it make more sense to recognize the durability of the capital markets in the face of all these threats rather than try to play hopscotch with our retirement assets each time a new one arises?
The below chart, courtesy of Dimensional Fund Advisors, does a really good job at illustrating this resilience. Note that each item along this timeline was accompanied by thousands of articles and TV segments discussing at length how bad things were going to get…
And so the key takeaway I hope I left people with was that they themselves constitute the number one threat to their own portfolio. It’s a sad but true fact – but it’s also very hopeful. Once you buy into this idea, you begin to take control of your future, even if you cannot control the future events that will shape our world.
Having a plan in place that’s been crafted in advance – and not just any plan but a damn good one – is superior to any kind of insurance one can buy after the fact. Plans should be agreed upon and adopted during times of clarity and sanity, never under duress. And most importantly, they should be revisited often so as to imprint their importance deep within our psyche.
And if we can commit to that, we’ve got a great shot at surviving whatever comes next.
Dividend Stock in Focus
Norfolk Southern (NSC): $109.23*
*price as of the close March 12, 2015
Before 1980 there were 39 Class 1 railroad operators and they were all struggling to stay afloat. Then several of the largest Northeast freight railroad operators went bankrupt. The railroads were reorganized under Federal control and were renamed Consolidated Rail, better known as Conrail.
It was clear that all the regulations created back during the Gilded Age were now crippling the industry. Back then railroads did not have to compete with trucks and highways, airplanes, and the revolutionary shipping container and the behemoth ships it lead to. During the Gilded Age regulation was needed to curtail widespread corruption and price gouging but the old laws prevented the railroads from adapting to new competition.
In 1980 under the Staggers Act the railroads were deregulated and a new golden age for the railroads emerged. The new legislation allowed the railroads to offer new services, contracting, and rate structures, which ultimately facilitated the consolidation of the railroad industry.
There are now only 8 Class 1 railroad operators with 4 dominant companies. Two West of the Mississippi river, Union Pacific (UNP) and Burlington Northern Santa Fe (owned by Berkshire-Hathaway). Two East of the Mississippi, CSX Corp. (CSX) and Norfolk Southern (NSC).
The rail networks that these 4 major companies own are hard to replace assets and extremely valuable. We want to own a piece of the East and West Coast networks. Norfolk Southern, which we’ve been buying since early 2012, is our Eastern railroad.
Over the last 10 years Norfolk Southern grew their dividend at a compound annual rate of 16.55%.
Norfolk Southern has a current yield of 2.10% and a 35% payout ratio giving the company plenty of room to continue to grow their dividend.
Catalysts for Dividend Growth and Price Appreciation:
Knocking the Rust Off the Rust Belt
One the best ways to invest in a growing U.S. economy is the railroads. The most economical way to move goods around the country is by rail. It may not feel like it but the U.S. economy is growing. It has been 6 years since the 2008 financial crisis and the U.S. economy has essentially broken even. The evidence is building that the foundations for long-term economic growth in U.S. economy are there. Take the Rust Belt for example as discussed in the New Geography article The Rust Belt Roars Back From the Dead.
Yet a funny thing has happened on the way to oblivion: the rustbelt’s industrial base is reviving. Cheap and abundant natural gas is luring investment from manufacturers from Europe and Asia, who must otherwise depend on often unsecured and more expensive sources of energy. The current energy and industrial boom, according to Siemens President Joe Kaeser, “is a once-in-a-lifetime moment.”
Indeed, since 2010, jobs have expanded in energy, manufacturing, logistics and, with the return of the housing market in some areas, construction. Although much of the expansion has taken place in the sunbelt, notably Texas, the rustbelt economy has also been a prime beneficiary. Of the top ten states for new plants in 2010, five were in the rustbelt—led by second place (after Texas) Ohio, Pennsylvania, Michigan, Illinois, and Indiana.
Most impressively, there has been a revival of job growth in these areas. Between 2009 and 2013, rustbelt cities and states dominated the country’s industrial revival. At the top of the list is Michigan, which gained 88,000 industrial jobs, a performance even greater than that of Texas, which came in second. The next three leading beneficiaries are all rustbelt states: Indiana, Ohio, and Wisconsin.
If you’re a global business looking for stable and low energy prices, existing infrastructure to build and move goods, increased access to one of the largest consumer markets, and want to operate under the rule of law then the U.S. is extremely attractive.
This is not to say the U.S. economy will go straight up from here; it will move forward in fits and starts. But, the foundations for good long-term growth are there and the railroads will also be there to move the raw materials and finished goods.
Intermodal is the long haul of shipping and truck containers. The rising costs, constraints, and environmental concerns of shipping by truck has lead to the growth of shipping by rail. Intermodal has grown so much that it has become the biggest part of Norfolk Southern’s revenue at 22% replacing coal which accounted for 21% of its 2014 revenue.
Intermodal shipping is expected to continue to keep growing as railroads can charge 10-30% less than trucks through the same shipping lane. Railroads also offer quadruple the fuel efficiency than trucking per ton-mile of freight.
Norfolk Southern has been investing in newer locomotives, heightening tunnels to allow double stacking of containers, and expanding yards to increase the efficiency of its intermodal shipping. Intermodal is a key growth area for the railroad operators and Norfolk Southern’s capital expenditures should allow it to meet the increased demand for intermodal shipping while maintaining pricing power.
Western railroad operators trade at a premium to the Eastern railroads due to their larger rail networks and the mix of freight that they haul. The Eastern railroads have historically traded at lower multiples because of the view that their profits are too dependent on Appalachian coal. Usually CSX Corp. and Norfolk Southern, the two major Eastern Railroads, trade at multiples in-line with each other. Occasionally, one trades at a premium to the other. When this happens the discounted company tends to outperform the premium company. Currently CSX is trading at one of its highest multiples in comparison to Norfolk Southern. We view this more as a short-term price catalyst for Norfolk Southern, since we expect both companies to be boosted by longer-term economic trends.
CSX Corp. traded at such a high multiple in relation to Norfolk Southern because it was reported that Canadian Pacific (CP) was in talks to merge with CSX Corp. The talks were called off back in October by CSX Corp.
We think the optimum number of US rail operators is two. One major railroad in the West and one major railroad in the East. With CSX calling off merger talks with Canadian Pacific it opens the door for Norfolk Southern. It also opens the door for BNSF to merge with Canadian Pacific too.
We view this as a longer term catalyst option. Regulators do not like an industry reduced to such few competitors even if it makes the most economical sense. Regulators do not like the perception that a railroad monopoly is forming even if the railroad operators still have to compete with trucks, ships, and air freight.
Pre-Mortem (Potential Risks to our Thesis):
Low Oil Prices
Low oil prices hurt the railroads in three ways. The first is lower oil makes the cost of shipping by truck more competitive with railroads. Second revenue per rail car is boosted by fuel surcharges. The higher the cost of oil the higher the fuel surcharge Norfolk Southern can add onto its contracts. Third railroads have been a big beneficiary of fracking. An increasing amount of oil produced from fracking in the U.S. is being shipped on railroads along with the goods and material to do the fracking. Sustained low oil prices will likely lead to fewer fracking projects and act as a headwind to Norfolk Southern’s revenue growth.
The silver lining here is that lower oil prices also mean lower fuel costs for Norfolk Southern which may help them maintain profitability. However, there is a time lag for lower diesel prices due to lower crude oil prices.
Coal is the most profitable freight that Norfolk Southern hauls. For the longest time coal was largest contributor to revenue on a percentage basis; it is now number two. Eastern coal is far more costly to mine and even more environmentally unfriendly than western coal. Increased EPA pressure and low natural gas prices are pushing Eastern and South Eastern power plants to shift from coal fired to natural gas fired. Also, the exports of metallurgical coal, the coal needed to make steel, is facing pressure from a stronger dollar and weaker demand as Europe struggles to get its economy growing again.
So far management has done a good job pivoting away from coal but coal is still its second leading revenue generator. Continued pressure on coal will weigh on Norfolk Southern’s future revenue and profitability and we need to make sure management continues to manage this effectively.
Over the next 10-20 years we expect railroads to provide great economic returns to their owners. As value conscious investors, the key is to not pay too much now for future benefits. If we overpay we lower our potential returns and if we drastically overpay we could negate them entirely. We rely heavily on our estimate of fair value to make sure we are not overpaying for assets.
Estimating fair value is part art, part science. When business factors change we have to reassess our fair value estimates based on the current environment. We must then weigh all probable future outcomes as of today to reach our estimate of fair value. We recently had to do this with Norfolk Southern because of the dramatic drop in oil prices.
What does lower oil mean for Norfolk Southern’s chemical shipping? For the industrial goods needed to drill for oil? What revenue does Norfolk Southern give up in fuel surcharges based on lower oil prices? What are the most probable outcomes going forward? And many other questions.
Our worse case scenario values Norfolk Southern at $80 per share and our most optimistic values it at $125. When we weigh our different estimates, more than the two mentioned, based on their probable outcomes and combine them with a dose of conservatism we come up with a fair value of $106 per share.
Norfolk Southern is trading just slightly above our estimate of fair value right now. As a reminder, fair value is the price we are willing to pay today to achieve a fair or reasonable return on the investment going forward. The greater a discount we pay to fair value, the higher our expected return. In the case of Norfolk, where we believe strongly in the long-term economic benefits of the business, we are willing to be a buyer at or near fair value.
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