Boy, I missed the absolute bonanza of a sale that occurred Monday, but I still scored a pretty good deal on a high-quality stock to finish off August.
If timing the market were necessary to achieve financial independence, I’d fail miserably. Fortunately, it’s not necessary and time in matters more than timing. Time in is something that I’ll very likely do really well with, now more than five years into this game. Very excited, however, to see where the next five years takes me. Obviously, I plan to stay invested in the wonderful collection of businesses I’ve amassed until I’m dead.
This most recent purchase involved a stock that I’ve been aggressively building a position in over the last few months. When I see a high-quality dividend growth stock that’s attractively valued and I have room for it in the portfolio, I’m likely to buy if I have capital.
I purchased 15 shares of Union Pacific Corporation (UNP, Financial) on 8/20/15 for $90.08 per share.
Overview
Union Pacific Corporation is the largest public US railroad, operating 32,000 miles of track that serves the western two-thirds of the country which includes some of the fastest-growing US population centers across 23 states.
Union Pacific connects with Canada’s rail system and they’re the only railroad that serving all six major Mexico gateways.
Founded in 1862, they now serve roughly 10,000 customers.
2014 freight revenue breaks down via the following six commodity groups: Industrial Products (20%), Intermodal (20%), Coal (18%), Agricultural Products (17%), Chemicals (16%), and Automotive (9%).
2014 carload composition was 61% domestic and 39% international.
A Large Position Built In Four Months Through Aggressive Averaging Down
I talk about averaging down all the time. If you like a stock at $100, you should like it even more at $90. And you should then love it at $80 or lower. Right?
Now, this is assuming that long-term fundamentals haven’t changed, but fundamentals don’t change very quickly. Prices do, though. And that’s where you find inefficiencies in the market. Prices on stocks can change rather radically in a short period of time. The last few days are a good example of that. But the value of these stocks aren’t changing that fast. Major companies don’t swing in value by tens of billions of dollars overnight outside of some major specific issue with the company.
Union Pacific is the same way. I initiated my position in the company back in early May at over $106 per share. I’ve since averaged down four times, concluding with this most recent transaction, which is approximately 15% lower than where I first bought stock in the railroad. Is Union Pacific as a company worth 15% less now than it was in May on a permanent basis? I find it unlikely, especially when I thought the stock was a pretty decent buy already at $106 after pulling back quite a bit. The stock is now down about 25% on the year.
And over the course of about four months I’ve built this position up to 50 shares now. Railroads now make up about 5% of the portfolio, which I find to be pretty solid, if aggressive, exposure to the industry. I think what this shows is that it doesn’t take long to build up a respectable position in a world-class business. Keep saving, keep investing, and keep looking for opportunities to average down on your cost basis if available.
Due to my exposure, however, I’m limited in terms of how many more purchases I can make here. I continue to find the stock very attractively valued and the business model outstanding. So it’s likely that I’ll purchase one more lot of 15 shares or so at some point in the foreseeable future and then call it a day. At that point, Union Pacific would be a rather large position. It’s then just a matter of sitting on those shares and collecting growing dividends for, hopefully, the rest of my life.
Notably, I was able to pick up shares just before the next ex-dividend date. That means my next dividend from Union Pacific will be calculated off of all 50 shares I own. I’m very much looking forward to that.
Risks
There are numerous risks with Union Pacific and other railroads.
There are extensive costs to maintaining a railroad. Unlike a lot of other methods of transportation, railroads must maintain their own networks. This is expensive – Union Pacific has invested more than $31 billion in its network and operations from 2005 to 2014. So the infrastructure there remains extremely valuable and probably impossible to replicate, but also expensive to maintain. In addition, there are significant input costs varying from labor to fuel.
Regulation remains omnipresent. Any negative changes here could have material impacts on Union Pacific’s costs to operate and/or ability to maintain profitability in a competitive manner.
As a railroad, it is exposed to the broader economy and all the ups and downs that comes with. Any major drop in activity across the economy as it relates to demand for goods could reduce demand for their services. However, they performed quite well during the recent Great Recession.
There are also black swan risks, including derailments and spills.
Valuation
The stock is trading hands for a P/E ratio 15.50, which is a pretty substantial discount to both the broader market and UNP’s five-year average P/E ratio of 17.5. In addition, the yield, at 2.44%, is about 70 basis points higher than the 1.7% yield this stock has averaged over the last five years.
I valued shares using a dividend discount model analysis with a 10% discount rate and an 8% long-term dividend growth rate. That growth rate seems fair considering it’s less than half that of Union Pacific’s own long-term growth rates for its EPS and the dividend. I’m factoring in the low payout ratio, growth forecast moving forward, and the extremely strong business model. The DDM analysis gives me a fair value of $118.80.
Conclusion
Oligopolies are always attractive. And seeing as how there are four major domestic railroads that account for almost 90% of all railroad business in the country, there are incredible competitive advantages built in here. While some industries can see oligopolies weaken over time, the natural barriers to entry that exist in this industry means it’s highly unlikely that any new entrants will come about. As such, Union Pacific (and the other three major railroads) is in a great position to grow its profit and dividend for a very long time.
This purchase adds $33.00 to my annual dividend income, based on the current $0.55 quarterly dividend.
I’m going to include current valuation opinions from other analysts below, which I use to concentrate my reasonable valuation estimate:
Morningstar rates UNP as a 4/5 star valuation, with a fair value estimate of $114.00.
S&P Capital IQ rates UNP as a 4/5 star “buy”, with a fair value calculation of $96.80.
I’ll update my Freedom Fund in early September to reflect this recent purchase.
Full Disclosure: Long UNP.
Think this stock is a good deal here? Why or why not? What are your thoughts on the railroad industry?
Thanks for reading.
