What’s new, right?
You know me. Available capital and a high-quality dividend growth stock at an attractive value are like a marriage made in heaven. Free cash might feel nice in the pocket or the wallet… and it actually smells pretty nice, too. But it doesn’t do much beyond that for someone looking to achieve financial independence via passive income, other than to serve as something to exchange for equity in wonderful businesses at fair or better values.
After all, a dollar bill will still be a dollar bill in 10 years, other than the fact that it will actually be worth much less than a dollar after inflation takes hold. But a great business can turn a dollar into two, then three, and eventually even five or ten dollars, plus pay increasing cash flow all the way along in the form of increasing dividends. It’s such an unfair trade, but it’s one I’m glad to make every single time.
And I made that trade once more.
I purchased 10 shares of Union Pacific Corporation (UNP) on 6/1/15 for $100.82 per share.
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.
Conviction And Averaging Down
I just initiated a position in UNP early last month before shortly thereafter averaging down and adding to that position. So this is the third time in a row that I’ve purchased shares in this world-class railroad.
And that brings me to an important point.
When you believe in a company, find that its stock fits your portfolio and available allocation, see the valuation is attractive, and have available capital, it makes sense to grab your BB gun and load up as much as makes sense at any given time.
Some investors – especially those new to the blog – might assume that I built my portfolio of 58 positions by just spreading out my capital across those 58 stocks as fast as possible. That’s actually not the case at all. I’ve rather typically built larger positions in a relatively short period of time – as fast as capital and other available opportunities would allow – by just buying the same stock pretty much over and over again over the course of a few months or so, before finding myself pretty well stocked up on that particular name and then moving on to other ideas.
Sometimes a stock will run away from me right when I find myself in a spot to build up a position, like Microsoft Corporation (MSFT) did somewhat recently. And some positions, like Armanino Foods Of Distinction Inc. (AMNF), are purposely smaller due to special circumstances. Otherwise, I try to maintain conviction when it comes to buying stocks, especially when a stock I recently bought trends downward in price, offering me an opportunity to average down and buy more stock (and dividend income) for the same amount of money.
Every investor needs to figure out a system that works for them, but I did want to point out the value in conviction. Doing the homework on a stock and liking it at $106 means you should like it even more at $101. As such, I was more than pleased with the opportunity to average down on UNP here. Letting the price drop somehow affect my logic would be a disservice – akin to letting the tail wag the dog. If you do your homework and you’re confident in the prospects, the chance to buy a stock even cheaper should be an event that you absolutely look forward to, assuming you still have room in the portfolio and available capital, and competing opportunities haven’t become somehow more attractive in the interim.
Ignoring a chance to average down means you’ll have to start all over again by analyzing another stock, which might be a poor use of time. Furthermore, it might also mean that you lack the confidence to put serious capital to work in any company.
I won’t reanalyze UNP since I just did that recently, but nothing has changed with the company. And that’s exactly why the further weakness has been so wonderful, in my view.
There are numerous risks with UNP 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 – UNP 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 UNP’s costs to operate and/or ability to maintain profitability in a competitive manner.
As a railroad, UNP 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.
UNP trades hands for a P/E ratio of 17.37. That’s attractive both in absolute terms and relative terms. Relative to the market’s P/E ratio of 20.64, you can see a lot to like here. In addition, this is in line with UNP’s own five-year average P/E ratio. So you’re getting a stock in line with recent historical norms against a market that’s quite a bit higher. As always, I think one should look at stocks on an individual basis instead of trying to judge the entire market at any given time.
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 UNP’s own long-term growth rates for 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.
UNP is down approximately 14.5% YTD, which is similar to most other major railroads. Value tends to hop around from one stock to the next or even from one sector to another over time, which is why, as aforementioned, I tend to focus on one or two stocks at a time before moving on to something else. When the value is there, I try to strike while the iron is hot. And if UNP drops another, say, 5% or 10% from here, I’ll very likely be buying more.
Railroads aren’t popular right now. Shipment volumes have declined a bit thus far this year, especially for coal. But I’m not looking at where shipping volume are at for the first quarter of 2015 or really any other quarter, for that matter. I’m looking at where Union Pacific might be 10 or 20 years from now. And I feel pretty confident that, due to massive built-in competitive advantages I recently wrote about, they’ll be a more profitable company, which should confer additional dividend income my way. Short-term volatility is a long-term opportunity when it comes to great businesses, in my opinion.
This purchase adds $22.00 to my annual dividend income, based on the current $0.55 quarterly dividend.
I’m going to include current valuation opinions from professional analysis services, as I use these to concentrate my reasonable fair value estimate:
Morningstar rates UNP as a 4/5 star value, with a fair value estimate of $115.00.
S&P Capital IQ rates UNP as a 4/5 star “buy”, with a fair value calculation of $116.50.
I’ll update my Freedom Fund in early July to reflect these recent purchases.
Full Disclosure: Long UNP, MSFT, and AMNF.
What do you think of UNP or the other railroads here? Value abound?
Thanks for reading.
Photo Credit: Stuart Miles/FreeDigitalPhotos.net