Warning: Railroad Stocks Are Expensive. What Should Investors Do?

Railroad stocks have been really resilient in this economic downturn. Some are even making all-time highs! However, they are all expected to experience earnings cuts this year on a GAAP basis, which is not surprising given the far and wide impact the COVID-19 pandemic is having on the global economy.

Stock Price Chart on North American Railroad Stocks

Railroad stock data by YCharts. The 1-year price action of railroad stocks: CN Rail, CP, UNP, NSC, and CSX.

In other words, these railroad stocks are getting expensive. Some are fully valued. Others are slightly overvalued.

The Best-Performing Railroad Stock: Canadian Pacific 

Canadian Pacific Railway (TSX:CP)(NYSE:CP) stock has performed the best in the last one-year and three-year timeframe. So, let’s take a deeper dive into it.

In the first half of 2020 (H1), CP’s revenue remained steady by growing 2% year over year to CAD$3,835 million. Operating income increased 18% to CAD$2,231 million, as it became more efficient over time. 

It reported a record Q2 operating ratio of 57% last week thanks largely to a meaningful reduction in fuel costs. Net income fell 10% to CAD$1,044 million, which equated to a decrease of 7% to CAD$7.64 on a per-share basis. Interestingly, CP’s adjusted earnings per share (EPS) rose 20% to CAD$8.49. So, management expects adjusted EPS growth this year. 

Its largest segments, Grain and Energy, Chemicals & Plastics, both saw meaningful growth, which drove freight revenue growth of 3% in H1. Their strong performance was dampened by double-digit drops in Coal, Metals, Minerals & Consumer Products, and Automotive.

CP’s Dividend Will Grow

CP plans to expand its payout ratio to 25-30% of its adjusted EPS. It increased its quarterly dividend by about 14% to CAD$0.95 per share (an annual payout of CAD$3.80). This equates to an estimated payout ratio of about 22% this year. Therefore, it has room to grow its dividend going forward.

CP Stock is Fully Valued

At CAD$367 per share and change, CP stock trades at roughly 21 times this year’s earnings (based on estimated adjusted EPS). Investors should wait for a pullback of 10-30% for a safer entry point. (It’d be a bargain on a 30% pullback from current levels.)

Source: F.A.S.T. Graphs. Showing CP stock’s valuation.

The Investor Takeaway

Railroad stocks are expensive at current levels. Returns will likely be ~0% over the next 12 months.

Another market crash can pull them down by 10-30%, at which time they’d be better buys

There’s high near-term selloff risks due to their high valuations and negative economic conditions.

Current shareholders might choose to hold railroad stocks if they have a long-term investment horizon, as these stocks will do well on future economic expansions.

Some investors want to limit trading in their taxable accounts. So, understandably, if they hold railroad stocks in taxable accounts, they would want to avoid paying capital gains taxes, especially if they still have a long way to go until retirement

I don’t think it’s a good idea to add shares at current levels, because they’re getting expensive. The stock market can crash again if large parts of the North American economy has to be shut down to reduce the spread of COVID-19. Another market crash can bring these railroad stocks to better valuations.

That said, if you fast forward a year, the cyclical stocks would be close to fairly valued. They’re bound to do well on a multi-year economic recovery after, say, vaccines are developed and distributed.

Some experts believe that COVID-19 will be here to stay much like the flu. Potentially, that’d mean in the future, people could be getting COVID-19 shots much like the flu shot.

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Disclosure: As of writing, we don’t own any shares of the stocks mentioned.

Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.

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