Finding Value in a Fair Value Market

Adem is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

"Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well"-Warren Buffett

I'm very depressed these days. I'm not kidding. With the Dow at 13k, housing turning around and months of better employment numbers investing is just no fun. In 2009 finding bargain priced stocks was like shooting fish in a barrel, now, it's like an ocean. In fact, a rational investor might think they should just go the safe route, put all of their money into savings. But you're reading this article--so you may be a few apples short of a full barrel already. For that reason alone, I'll humor you and see if we can find a real value at Dow 13k.

What Value Looks Like

Before I get to the stocks I like, let me explain my view of "real value." The investment world if full of choices. Investors can put their money in stocks, bonds, CD's or even precious metals; the choice is theirs. Personally, when the market is at a top or at fair value (like I believe it is now) the only stocks I'll consider are long term value stocks.

Regarding those choices, for our purposes, a true value stock will have to outpace the (near) risk free investment we could receive by simply buying treasury bonds. Since today’s treasuries are yielding just 2.5% on 30 years, that shouldn't be hard to find. So rather than using a discounted cash flow analysis or measuring the return on invested capital, let's look for stocks offering most of that yield by way of dividend. While the former two methods are great for calculating a hypothetical return, a dividend is hard cash in our hand; can't beat that.

There is also a ying and a yang to a true value stock. It goes like this: a value stock needs to have a depressed price and be out of favor while still having good long term catalysts for growth. If a stock is unloved by the market and you can't find any good reason to love it either, that's not a value stock. That's a bad stock. So what we want is bad stocks, not bad companies. Something that's out of favor, unloved with two or more catalysts for long term growth.

So how can we find our way to true value in this market? Let's take the rails.

Happy to Buy Sad

My friends, it's time to love the unloved. We can’t find a stock that the market misunderstands if the market loves it already. The rails have gone from a very hot sector, with over 20% EPS growth to an abrupt halt. This price decline if nothing else puts the rails at good valuations and has moved up the dividend yields to levels where we’re beating the return of treasuries, meeting our first metric.

<table> <tbody> <tr> <td>Company</td> <td>P/E</td> <td>P/EG</td> <td>Dividend Yield</td> </tr> <tr> <td>CSX Corp. <span class="ticker" data-id="203228">(NYSE: <a href="">CSX</a>)</span></td> <td>11.3</td> <td>0.87</td> <td>2.7%</td> </tr> <tr> <td>Norfolk Southern Corp. <span class="ticker" data-id="204749">(NYSE: <a href="">NSC</a>)</span> </td> <td>10.43</td> <td>0.79</td> <td>3.30%</td> </tr> <tr> <td>Union Pacific Corp. <span class="ticker" data-id="205900">(NYSE: <a href="">UNP</a>)</span></td> <td>15.19</td> <td>1.05</td> <td>1.90%</td> </tr> </tbody> </table>

The reason for the decline has been largely because of a decrease in coal carloads from anywhere between 15-25%, due primarily to declining natural gas prices taking away utility customers. However, when we dig a bit deeper into the numbers, the news isn’t all bad.

Remember, a cheap stock is not a good stock, we need to see a brighter tomorrow. Luckily the rails do not disappoint as they have several long term catalysts, let's take a look.

Coal—Not as Bad as it Seems

Yes, the past two years (this one particularly) have been terrible for coal. Yes, this is due largely to natural gas prices being at all time lows. Finally, yes, this cannot last forever. Natural gas is not milk; it, like coal, is not an abundant resource. There is a finite amount of it and at some point those prices will rise. Furthermore, even with natural gas prices so low, coal has only really suffered the worst blows domestically, not on exports. In fact, worldwide coal production is still expected to increase well over 50% by 2035, according to the U.S. energy information administration. In other words, while you may have to wait (the value investor’s credo) coal is not dead, we need coal.

A Small Pool of Competitors

Competition, it’s one of those things that’s great for consumers but awful for investors. In short, there is very little competition in the rail industry as they operate in an oligopoly with a very limited number of large sellers. You have UNP and Berkshire Hathaway’s (NYSE: BRK-B) BNSF in the west, with CSX and NSC in the east; together they make up 80% of the industry's revenues! They enjoy a huge moat, the rail has already been laid, giving would be competitors an enourmous barrier to entry. Let that sink in for a moment, it's a large reason the rails have been able to raise their prices an average of 13% per year, the past three years.

Trends are Your Friend

If it was only for the coal trends and dominant market positions, I’d be recommending Joy Global (NYSE: JOY) a manufacturing company that serves the coal and copper mining industries, to you today. At its current dead cheap valuations (P/E 6, P/EG only 0.53) Joy could very well be a long term win as well, but the thing I love about rails is that they benefit from so many other trends. Look at this revenue mix from these three, large, U.S. rails

<table> <tbody> <tr> <td>Company</td> <td>Coal</td> <td>Housing and Construction related</td> <td>Agriculture</td> <td>Auto, auto related</td> </tr> <tr> <td>CSX Corp. <span class="ticker" data-id="203228">(NYSE: <a href="">CSX</a>)</span></td> <td>26.2%</td> <td>11.9%</td> <td>14.7%</td> <td>8%</td> </tr> <tr> <td>Norfolk Southern Corp. <span class="ticker" data-id="204749">(NYSE: <a href="">NSC</a>)</span></td> <td>26.1%</td> <td>11.8%</td> <td>12.9%</td> <td>10.1%</td> </tr> <tr> <td>Union Pacific Corp. <span class="ticker" data-id="205900">(NYSE: <a href="">UNP</a>)</span></td> <td>12.06%</td> <td>18.6%</td> <td>13.9%</td> <td>15%</td> </tr> </tbody> </table>

Ok, time for some facts. First, the world has 7 billion people to feed, which will rise to 9 billion by 2050.  Second, housing is starting to recover. Yes, housing starts jumped 15% in September, the highest level in four years and over the past 12 months work began on 34.8% more new homes. Note, these are new home sales figures, not foreclosures, rails ship new home goods. Third, the auto industry has contributed the largest % to our GDP the past two years, of any sector. So you tell me, with favorable long term projections for coal as well as long term catalysts in housing, auto, and agriculture to pick up any needed slack how will the rails lose--for a long-term investor?

The Halo Effect

Now it’s time to let you in on the biggest catalyst of all. Fact: gasoline and oil prices are near all time highs. Fact #2: by 2035, the price of a barrel of oil is expected to skyrocket to $200 a barrel based on a 35% increase in global consumption. Fact (the good news) #3 it is 3 times more fuel efficient to ship goods via rail then it is by highway. Need I say more? Ok, I will.

In addition to the fuel savings driving customers to rail (hence the 13% price increases) as we go forward the rails will benefit from the support of everyday soccer moms. I believe, they will enjoy the same sort of halo effect that socially responsible firms like Starbucks and Whole Foods enjoy and I’m dead serious. As climate change becomes more of an issue, as we run out of fuel, those CSX “how tomorrow moves” ad spots will sink in more with the general public. Big advantage.

A Matter of Perspective

Every market has a winner, regardless of where the Dow is. My view, is in situations like this, I want to be in stocks that are misunderstood, with long term catalysts. The rails have made Mr. Market sad, yet they still have a bright future. If you’re a truly long-term investor, you can’t beat this opportunity.

Fact: I’m not feeling as depressed anymore.



 Adem Tahiri owns shares of CSX. The Motley Fool owns shares of Berkshire Hathaway and Joy Global. Motley Fool newsletter services recommend Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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