I am not going to discuss how I have struggled to manage my body weight during the COVID-19 pandemic. Working from home with endless snacks, stretchy pants, and many canceled activities has been an issue!
But I will discuss a routine question we ask ourselves: what weight should Company XYZ be in the portfolio? In these updates, we have examined the components of Quality and Value in our process; however, there must be a balance between the two.
When describing our investment philosophy and process, one of my favourite examples of franchise quality is the Canadian railway industry. Canadian Pacific (CP) and Canadian National (CNR) railways have track running across Canada and into the US. Solid volume growth, well managed balance sheets, respectable returns on their invested capital and robust pricing power (as evidenced by consistent price increases above annual GDP growth) are excellent features. Even with these quality components, we do not automatically hold these businesses at our maximum 6% weight. This is where valuation comes in.
Source: QV Investors & S&P Capital IQ
The shaded area in the chart above shows the blended price to earnings ratio of the two Canadian railways. The green line reflects the blended stock prices. In the first two months of 2020, CP and CNR were trading at valuation levels close to their peaks over the last 20 years. We decided to lower our weight at that time due to the increasing valuation risk. As we all know in hindsight, this was a couple months before CNR and CP, alongside most equities, entered a bear market. Importantly, the merits of these two companies did not change during the COVID-19 sell off, however the valuations greatly improved. We moved aggressively to increase our Canadian railway exposure by over 40%. We do not tend to trade as much as this chart suggests; however, we also don’t typically see such large valuation moves in a short period of time.
As a portfolio manager, it can be difficult to buy in a bear market, but it is much easier to do if you believe these companies will be around for the recovery. The business franchise must be strong enough – and importantly, so must the balance sheet – to withstand temporary declines in cash flow.
It feels like we have gone through an entire business cycle in 14 months. If we look back to the chart above, railway valuations have moved swiftly in the first few months of this year, now at record levels. This is partly due to the railways factoring in a recovery; but even then, we feel they are trading higher than may be warranted. As a result, we began selling our railways. Then something happened.
THE BIDDING BEGINS
Near the end of March, CP announced a friendly merger agreement with Kansas City Southern (KSU). The strategic rationale was clear, with CP’s track ending in Kansas City where KSU’s begins, creating a continuous North American railway. The issue for us is the debt required to combine the two. When any QV holding enters a material acquisition agreement, we analyze the transaction with our acquisition scorecard. It looks at items such as the estimated return on capital based on the price paid and the additional revenue and cash flow expected. We look at synergies with a cynical eye because announcing synergies and executing on them are two very different things. Our scorecard identifies the debt levels relative to the history of the firm. The merger would increase CP’s debt metrics to the highest they’ve ever been. In light of this proforma debt alongside an all-time high stock valuation, we reduced the weight of CP again.
At the end of April, CNR announced a higher competing bid for KSU. CNR didn’t want to see its largest competitor take this coveted asset into its network. Like CP, KSU would allow CNR to extend its North American reach. If CNR were to win this bidding war for KSU, we would also see its balance sheet move to historically high levels.
These companies are key competitors. We don’t know if these are the final offer prices or who will be the ultimate winner. What we do know is that the Canadian railways are at elevated valuations with the potential for one of them to take on a lot of debt. To manage this risk, we have reduced our weight in both to below average positions. Once the dust settles, we can then re-evaluate based on where KSU lands. Some may ask, why not sell them both out of the portfolio based on their current valuations? While the valuations are elevated, these businesses are also above-average in terms of quality. Regardless of where KSU lands, we believe that both companies can still benefit the portfolio.