Investing in the current environment is challenging, and there is really no other way of putting it. There are substantial macroeconomic headwinds that threaten to hit growth and curb investment plans, which will have knock-on effects on other industries.
What’s more, inflation is pushing up the cost of labor. This could be particularly painful for businesses with large, expensive labor forces, especially unionized workers. Companies will have to increase wages, which will mean they will have to hike prices for consumers.
With wages rising, consumers might be willing to pay the higher price, but that is assuming there is no competition. In highly competitive markets, companies will not be able to pass higher costs on to consumers. If they try, they will lose market share. They might be able to maintain or even grow sales due to higher prices, but at what cost?
This is the challenge investors face today. Different economic headwinds will have different impacts on companies. One sector that stands out today as being somewhat immune from these trends is the resource sector. Rising commodity prices are pushing earnings higher for these companies. However, if they have to raise wages and commodity prices slump, they will not be able to cut wages. Then these businesses will face the double hit of lower revenue and higher costs.
So, in this market, where do investors hide? One sector that seems to have quite a few of the qualities required to weather the storm is the railroad sector.
Looking for protection with railroads
North American railroad operators Canadian National Railway Co. (CNI, Financial), Union Pacific Corp. (UNP, Financial), Canadian Pacific Railway Lt.d (CP, Financial), CSX Corp. (CSX, Financial) and Norfolk Southern Corp. (NSC, Financial) all sit in unique, almost monopolistic positions.
Over the past couple of decades, these businesses have zeroed in on cutting unprofitable routes and maximizing returns from their existing tracks. A large part of this has involved cutting back duplicate routes and squeezing efficiencies from existing facilities.
The impact this has had on profits cannot be understated. Union Pacific's operating profit margin has risen from 36.3% in 2016 to nearly 43% today.
Their market positions give these businesses the pricing power to hike costs to customers without having to worry about too much pushback. At the same time, while these companies are exposed to labor issues, they are better positioned to handle rising labor costs than other corporations. They have substantial economies of scale and have more scope to drive efficiencies through better working practices.
The railroad industry is pretty unique in many respects, but perhaps most importantly, it is very challenging to build new networks. Unlike other sectors, where competitors can just build new capacity, building new railroads (that actually go somewhere people want to go) takes a huge amount of time, money and political willpower.
These barriers to entry help define the operators’ competitive advantages. Further, as the world becomes increasingly aware of the impact of companies’ activities on the environment, railroads could benefit.
Given the sustainability and efficiency of utilizing railroad transport over that of truck haulage and air delivery, railroads have the advantage. They may also become much cheaper if policymakers try to force users away from carbon-intensive transportation methods with taxes. As it is pretty difficult to build new railroads, the existing operators will have the upper hand.
So given all of the above, it seems there is a strong argument for owning railroad stocks in the current market. They have huge economies of scale, strong competitive advantages and are perfectly positioned to grow in a world concerned about the environment.
With these factors in mind, Union Pacific’s forward price-earnings ratio of 18.1 does not seem too demanding. CSX is the second-cheapest of the pack. And for inventors who want to own a railroad alongside other businesses, Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) owns BNSF, which sits alongside Union Pacific as one of the largest operators in the country.
