The CN Rail Cash Machine

CN Rail reported their Q3-2010 result; it indicates they have recovered well from the economic crisis.

Although CN’s equity price is relatively high in terms of the cash they are able to deliver to shareholders (most notably they are spending about $300M/year above the rate they are amortizing), there are worse places to put “stable” cash – the equity trades more like a bond. This is another example of when people talk about “asset classes” that you cannot just put a blanket on “Canadian equity” and consider every share of every corporation to have the same risk/reward characteristic.

In terms of the actual numbers, the business was able to generate about $2.78 per share of free cash flow over the past 9 months. Annualized, this is about $3.71 in free cash, on top of a $67 equity price justifies the “relatively high” remark with respect to valuation.

Despite the high price (which is very near all-time highs), it is likely that CN’s total return over the next 10 years will outperform the equivalent Canadian 10-year bond, which yields 2.74%. The railways (CN and CP Rail) will likely be successful cash generating entities as long as Canada and the USA remain politically stable, and also are a benefactor of high energy prices – freight rail competes very well against trucking when it comes to goods movement.

Unlike most utilities, all railways have one very valuable piece of paper which is impossible to obtain – the right of way in major urban centres. If you were to give somebody $100 billion from scratch and got them to construct a railway, there is no way you could transform that capital into an income-bearing instrument that would yield better than the government bond. One of those reasons is property acquisition and track right of way – something Warren Buffet was thinking about when he bought out Burlington Northern. The only way you’d be able to get any sort of reasonable return is just to buy the railway outright, but even then the government could step in, citing “national interests”.

Toronto Money Show

I notice Susan Brunner has a good summary of some talks she attended at the Toronto Moneyshow. If she ever comes to Vancouver (or even if she is reading this), I will extend an invitation for coffee.

I know the Moneyshow (formerly Financial Forum) comes to Vancouver annually in February and I always make it a point to attend simply because if there are any dominant themes, I usually then yellow-flag them as a sign that the investment thesis has reached public saturation.

Just judging from Susan’s remarks, one can take the following as consensus:
– Negative on the US; all mentioned some form of a medium to long-term bear market with little equity returns;
– Government bonds over-valued (yields too low);
– Yield-bearing securities, including Canadian Banks, and various sorts of income trusts that will be converting to corporations, and in general anything with sustainable yields with a prevailing view of deflation;
– Some projected inflation. There seems to be a division of people in both camps;
– We are in the middle of a natural resource bull market for roughly the next decade;
– Most growth opportunities will be offshore in developing countries;

So these expectations are probably priced into the marketplace. It is a matter of determining whether things will actually occur as market participants are pricing, or whether the scenario will deviate.

Indeed, if the world believes that commodities are going up, there is a chance that demand could be even higher than expected. It is the equivalent of making a small-odds bet on a probable event – you will still be rewarded for getting it right, just not as well rewarded for betting on something very obscure and mis-priced that turns your way.

A relatively quick trade

I am now slowly unwinding my trade in Davis + Henderson Income Fund (TSX: DHF.UN). If the units go higher by approximately 5%, I will be exiting the entire position compared to the partial sale of my position as of this writing.

While I do not have concerns about the stability of their distributions (especially as they will be reduced 35% or to $1.20/share after they convert to a corporation), I do have concerns about the ability of management to grow the company’s free cash flow from existing levels. They have been pursuing a strategy of growing revenues and income through acquisition, which is generally a risky method compared to growing organically. So far, it has worked for them. The question is whether it will continue to doing so – which is never a given.

This company is not unique at all in the income trust sector to being bidded up. All sorts of income-bearing securities are becoming very expensive.

Although DHF will pay 5.85% a year (at 20.50 per share) in eligible dividends in 2011 when they convert to a corporation, I do not think this cash stream is worth paying the current price for given other investment opportunities – none of which give yields.

What I find interesting is it is likely retail investors that will be focusing on the 5.85% yield instead of looking at the underlying business and asking what they are purchasing. I am not complaining – I am taking this opportunity to take some more of my portfolio off the table and holding yet even more cash for future deployment.

The net gain is approximately 25% above cost basis; not factoring in the few distributions that occurred between the purchase price and the disposition, not bad considering that the upside is more limited than the downside.

What to do when your shares rise

Long-time readers should be able to see this chart and know what security I am talking about, but I have purposefully omitted the name and ticker and price scale just to illustrate. The security in question is quite “yieldly” so it is susceptible to the huge increase in demand we are seeing for income-bearing securities.

Here is a 3-year chart:

Here is a 6-month chart:

Finally, here is a 1-day chart (approximately up 7% for the day):

There is seemingly no fundamental news involved, which makes me suspect this was purely technical trading occurring. The volume was not excessively high compared to average volume.

Question – do you sell the spike? Do you get greedy and see what happens the next week?

Fundamentally speaking, the security involved is priced slightly above my fair value range. It already consists of a relatively large fraction of my portfolio, so choosing to lighten up is the obvious answer. I can’t help but think, however, that by getting “greedy” that I can get an extra 10-20% out of this that I would otherwise have not received by using a more fundamental trading method. By scaling out of your positions slowly, exiting piece by piece as the price goes higher, you can participate in some upside, but continue to reduce your risk as the price continues to rise.

2010 capital gains are starting to be a big concern for me tax-wise, but fortunately there are some units of this security in my RRSP that I can start off with on a tax-free basis.

Inflation and the markets

There hasn’t been too much going on in the markets – the undercurrents feel very swift, however. There is the specter of the looming currency wars, which seems to be the 21st century version of trade protectionism – where all currencies have a race to the bottom.

This is likely to result in the increase in commodity prices, and we are already seeing this in items like sugar, grain, etc. Increased commodity prices is the first step in the erosion of purchasing power of cash.

Whether the statistics are reported by the consumer price index or not is irrelevant – it is clear that the purchasing power of currency is dropping, more than what most people perceive. Not helping matters is very loose monetary policy, where institutions can borrow money for very low rates and then lend it long – this inflates asset prices as capital searches for yield.

The games that sovereign governments are playing are only going to accelerate as debt loads continue to increase – there is no way, for example, that the USA has a reasonable chance of balancing its books, or even paying off the debt without a massive restructuring. The least painful and least politically costly way of doing this is to inflate the currency.

Both retail and institutional investors have to be very cautious that the game with currencies and asset values will result in a lot of pain for all involved, as it will accelerate market volatility. The only apparent escape is to purchase assets that have a claim to cash flows derived from an inescapable consumer need, such as fuel or food. Even in those two cases, you have to purchase a future claim to a cash flow at an acceptable price, which is ever fleeting in today’s marketplace.

It is ironic that the best claims to future cash flows I have found are in non-dividend or very low-dividend bearing securities. Almost anything giving off cash has been bidded up to unacceptable levels.

The only argument against all of this is that you would suspect that government bond yields would be increasing when the markets sense such “stealth” inflation is occurring, but this has not happened yet due to the federal reserve’s quantitative easing program, which has created an asset bubble.