Dodge & Cox Comments on Union Pacific

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Aug 15, 2016

While scores of railroads once operated in the United States, the industry is now concentrated: there are two major railroad lines east of the Mississippi and two in the West. We recently initiated a position in Union Pacific (NYSE:UNP), which owns an irreplaceable railroad franchise covering 23 western states.

The North American railroad industry has many attractive characteristics: companies operate in regional duopolies and have high recurring revenue, substantial ability to control their costs, and extremely high barriers to entry. Union Pacific has the opportunity to increase its earnings as a result of growth in its domestic intermodal business, as well as a construction and housing recovery in the West. In addition, continued growth of the Mexican economy and increased trade with the United States should benefit its U.S.-Mexico business. With low leverage and a projected reduction in capital expenditures, management has the ability to increase share buybacks over our investment horizon.

In 2015, Union Pacific faced the perfect storm of challenges, including record low natural gas prices that suppressed coal volumes, a significant reduction in oil and gas drilling activity, a strong U.S. dollar that hurt exports, and a broad slowdown in global trade. These factors combined to cause the biggest decline in Union Pacific’s traffic volume since the 2009 recession, and its stock underperformed the S&P 500 by 34% last year. While these headwinds are substantial, we believe that most of them are largely cyclical rather than structural in nature. Therefore, we believe these short-term concerns have created a rare opportunity to initiate a position at an attractive valuation. Over the last decade, the company has generally traded at or above S&P 500 multiples but now trades at a discount. On June 30, Union Pacific represented 1.4% of the Fund.

From Dodge & Cox's second quarter 2016 shareholder letter.