Simon Edelsten: Travelling back to the future with US railroads

It’s 130 years since the first investment trusts backed US railways. Today, they look appealing again to UK investors worried about inflation.

The first American rail journey didn’t go very well. In 1829, the Delaware and Hudson Canal Company imported an English locomotive, the Stourbridge Lion, to take freight down a short line and bypass one of its canals. Unfortunately, nobody had checked whether the bridge or tracks on the route would bear its seven-ton load. It was a one-way trip.

Nonetheless, as in the UK, it soon became clear that ‘railroads’ were the future. By 1859 American railroad corporations had floated bonds worth over $1.1bn, and so heavy was the trading volume in railroad equities that shortly afterwards the New York Stock Exchange opened its first permanent exchange – on a little-known corner of Lower Manhattan called Wall Street.

The next 70 years saw more than 200,000 miles of track laid. Some of our older investment trusts, founded in the late 1860s and 1870s, found serious growth opportunities in US railroads (though inevitably this became a bubble that had to burst).

US railroads look appealing to UK investors again today. There are about 700 companies, though most are tiny. We own two of the big five or so that are most likely to interest investors. These are Norfolk Southern (NSC.N), which spans 22 states and 35,000 miles of track, and Union Pacific (UNP.N), which stretches across 23 states and 32,000 miles.

This is a good time for rail. US railroads primarily carry freight, with passenger services limited largely to mass transit of commuters in cities. As the US recovers from the pandemic, transport volumes are ticking up.

The industry has also quietly benefited from consistent investment and new technology. Safety improvements, smart logistics and high-tech precision scheduling have enabled railroads to run longer trains – over a mile and three-quarters long – that are more likely to arrive on time, enhancing efficiency and attracting custom.

Inflation protection 

The post-Covid recovery has reintroduced inflation to the global economy. It looks like a persistent issue that investors need to address. Railroads will face cost increases in labour and fuel, but these should prove modest compared with those facing their rivals in the trucking sector – railroads compete with road haulage in higher-value cargos.

Claims are often made that equities can cope with higher inflation. These claims are less often well founded, but we have a century of evidence to reassure us of how well railroads manage inflationary pressures. The American rail industry should be able to pass on most of these pressures through higher rates. Union Pacific announced its third-quarter results recently and showed revenues 13% higher on the back of 5% volume growth. Profits after costs were up 20%.

Demonstrably, this is a company that can pass on its increased costs. In part, this is because US rail businesses face much less regulatory pressure than those in the UK. There is a law that states they should be able to attain a fair return on their capital investment (so-called ‘revenue adequacy’). Some measures allow customers to appeal against excessive price rises – to avoid monopolistic practices – but these have seldom been invoked. Rate rises are generally easily understood and accepted by the major users of freight rail.

Sustainable investing 

While this might be enough of an attraction for some investors, others will prefer the sustainability driver. In the US rail currently moves 45% of all long-distance freight yet produces only 7% of freight carbon emissions.

The German government has calculated that moving freight by rail produces six times less CO2 than by trucks. It found that an average freight train emits around 18 grams of CO2 per tonne-kilometre, while road haulage emits 112 grams.

Union Pacific and Norfolk Southern both say they move a ton of freight 444 miles on a single gallon of diesel fuel. CSX (CSX.O), another operator, says it managed 508 miles.

And rail systems are getting greener. Earlier this year Norfolk Southern became the first major North American railroad to issue green bonds – to help it reduce its carbon emissions. It is adopting measures such as further modernising its engine fleet and replacing diesel cranes with hybrid or electric cranes.

Carbon-reduction policies 

Sometimes the carbon-reduction policies of governments seem fixated on energy supply. Investors can become very focused on avoiding fossil fuels within their portfolios (we do) and supporting wind farms (we did till recently when the prices became unviable).

It is just as important to look at energy efficiency and lowering pollution levels within the existing infrastructure.

This is also an example of making better use of what we already have rather than heading for trophy-building projects for new infrastructure with the carbon cost and expense associated.

No investment is perfect. Some investors may object that coal is still one of the US railroad’s main cargos, but this will fall in volume over the next 30 years as the US heads to net-zero emissions.

Railroads are an important element of the journey to a low-carbon world. They can be a useful component in a well-balanced portfolio, too.

Simon Edelsten is co-manager of the Mid Wynd International (MWY ) investment trust and the Artemis Global Select Fund . Any opinions expressed by Citywire, its staff or columnists do not constitute a personal recommendation to you to buy, sell, underwrite or subscribe for any particular investment and should not be relied upon when making (or refraining from making) any investment decisions. In particular, the information and opinions provided by Citywire do not take into account people’s personal circumstances, objectives and attitude towards risk.

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