Today's market seems to be relentlessly driven by growth and more growth, and we, along with so many others, like a variety of high growth areas. We detailed a number of them in recent pieces, and you can read more on our views of huge industries such as biotechnology, payments, as well as smaller growth areas such as animal health, among others.

Yet in this growth-driven market, we still believe there is opportunity to be had in other, perhaps less exciting businesses. Put simply, we believe a company that is a steady revenue grower with a good cost structure and a reasonable valuation can still be a winner. We believe that a select few North American railroads are offering exactly that combination today.

Starts with the Economic Cycle

Railroad operators are cyclical businesses whose fortunes rise and fall with the broader economy. In some cases, these so-called cyclicals can oscillate wildly as the economy swings from recession to recovery to expansion, and back to recession again.

During the depths of the pandemic, the rails were not immune. Falling volumes hurt sales, and the rails generated one of their most weak revenue growth years (excluding fuel surcharges) since the Global Financial Crisis. As the economy re-opened, and as business activity picked back up, the railroads were there to benefit. Volumes rebounded, and organic revenue growth looks set to bounce back near double-digit percentages year-over-year, at least for some railroads. Long-term, investors would be wise to expect total revenue growth around the rate of GDP growth for an average year. Significant, but not the type of growth that in any way compares to some of the other opportunities we mentioned in the intro.

The Value of Precision

In our view, the pricing power characteristics and barriers to entry for railroads are essentially the same as they have always been. Railroads are extremely capital intensive, literally requiring billions of spend each year in maintenance costs. It would be nearly impossible for a new entrant to compete with existing players.

The rails also continue to raise prices at a steady clip for several reasons. First, the industry has consolidated down to 7 rails, and they each operate in different geographies as to reduce competition. There are also few substitutes for a large percentage of the cargo that they carry, and in our estimates, that figure is as high as 70%. Their ownership of their networks, small share of total shipping costs, and demonstrated recent track record of pricing power all suggest that their revenue growth trajectory remains stable.

Beyond the top-line, in recent years the cash flow generation of the rails has materially improved as a result of the adoption of what is known as Precision Scheduled Railroading (PSR). PSR has become an industry standard, and it was first adopted by a US railroad in 2017 by famed CEO Hunter Harrison. The basic principles are to operate a more agile railroad with less traffic congestion, fewer equipment, and fewer employees. This is achieved by running fewer longer and heavier trains, reducing the need for as many locomotives, operators, railyards, and fuel. The result has been an evident reduction in the expense profile of the entire industry, and a material improvement in free cash flow generation.

Wringing Out Efficiencies

When investing in railroads, one counterintuitive notion is that the best investment opportunities are often with the operators that seem least attractive at a glance. This is a unique situation to the rails.

Thanks to pricing and implementation of PSR, the rails have been improving their operating ratio for years, and over the long-term, we believe that today’s railroad operators are not too dissimilar from one another. This lack of differentiation is why, again over the long run, we would expect them to operate with relatively similar margin ratios. As a result, we believe the best way to invest in railroads is to own the high-cost operators today, those with the worst operating ratios, because we would expect them to ‘catch up’ to their competitors and deliver above industry growth going forward. We believe an underperforming railroad never stays the worst on margins as either an activist investor gets involved or enough shareholder pressure is applied to incentivize the current management team to improve margins.

We believe the current backdrop sets up well for a select few North American railroad operators. While we like the business characteristics of the industry as a whole, due to the nature of railroads, we believe a selective approach should be preferred as certain operators have more attractive investment characteristics today than others.

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This material contains the opinions of Manning & Napier Advisors, LLC, which are subject to change based on evolving market and economic conditions. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. The reader should not assume that investments in the securities identified and discussed were or will be profitable.