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In this blog, we will discuss the Fed’s latest interest rate hike, what to do when ‘cash is trash,’ and give you a short primer about the US railroad industry, which has been outperforming the S&P 500.
Fed’s latest interest rate hike
This past week, the Fed (the US Central Bank) announced it would increase the US benchmark interest rate by another 0.75%. This is the third consecutive “jumbo” hike this past year, one of the fastest rate policy increases in decades. This means that the new target interest rate is between 3.00 – 3.25%, which is expected to further increase to 4.25 – 4.50% by the end of the year.
The Fed’s resolution is firm. It is determined to continue with the large hikes to break the current stubborn inflation.
“I wish there were a painless way to do that. There isn’t.” – Chairman Powell, Chair of the Federal Reserve Board.
The upside of increases in interest rates is that it opens up additional alternatives for investors to park their money.
Cash is trash – even more so if you’re holding emerging market currency
In every public appearance, Ray Dalio, the famous hedge fund manager, espoused “cash is trash”. Due to the high level of inflation, investors are losing purchasing power from the cash they hold. For some investors, holding cash is a necessity, perhaps because you may need the cash in the near future or because you want to avoid the stock market during periods of heightened volatility. Regardless of the reason, the cash that investors hold must be parked somewhere. Ideally, in a vehicle that avoids loss of principal as much as possible and can be liquidated at will. As such, holding cash in a bank account might be the best option for some folks.
But for emerging market investors, holding cash is doubly bad. Not only does inflation erode the value of your cash holdings, higher US interest rates, which translate to stronger USD exchange rates against other currencies (this is something we’ve discussed more deeply), also reduces the value of your cash holdings.
Take the Indian Rupee (INR), for example. Since the beginning of the year, it has depreciated against the US dollar by 9% (see Figure 2 below). This is despite the fact that the RBI has been defending the Rupee by spending more than $100 billion from August 2021 – 2022 (which translates to a 14.3% decline in the RBI’s currency reserve).
This means that:
- On a cash vs. cash basis, the INR vs. the US dollar has declined by -9% in the first nine months of this year (for simplicity, let’s put aside the effect of inflation for a moment).
- But you might be thinking that the average bank interest rate in India is higher. As of this writing, the average <1 year fixed deposit rate in India is 5%. In contrast, the average bank account interest rate in the US is 0.4%. So, the difference is 4.6%. This means that if you had deposited your INR in a short term FD, your Rupees would have depreciated by -4.4% when compared to the dollar.
But, with increasing interest rates in the US, in order to get additional yield, there’s one alternative to storing your cash in a bank account:
Invest in short-term Treasury bond ETFs such as SGOV (iShares 0-3 Month Treasury Bond ETF) that holds 0-3 month maturity US Treasury bonds. With increasing interest rates, yields of these super short-term US Treasury has been increasing. In the past 30 days, the yield has increased to 2.7%. There are two reasons why one might prefer these super short-term Treasury bonds: (1) With increasing Fed target interest rate, this increase will propagate to the US Treasury Bond as well (with a one-month lag). By the end of 2022, expect the yield of these super short government bonds to be ~4% as well. (2) Super short-term government bonds do not fluctuate much in price and have less interest rate risk, providing additional principal stability. In the short term, this ETF has been around (started in May 2020), and its average daily return is -0.001%, with a standard deviation of 0.008%.
Ok, so let’s go back to our comparison. As we’ve established above, by September 2022, holding the equivalent cash in US dollars gives you a +4.4% advantage. If, rather than storing in a bank account, you invest in super short-term US Treasury bonds, you can increase your yield by another ~3%, to give a +7.4% advantage. By the end of the year, with the expected yield continuing to increase, that advantage might widen between +8.4 and 9.4% (compared to holding cash in Rupees). But of course, converting INR/USD incurs costs, so we deduct ~2 – 3% (for FX fees, which vary depending on your bank), to give a final estimated delta of +6 to +7% in favor of holding super short-term US Treasury when compared to keeping cash in a fixed deposit in India.
The higher interest rate regime also means that investing in cash generating companies might be more prudent in the near future. Here’s an example.
A short primer in the business of US Railroads
When seeking a company to invest in this economy, one might look for recession-resistant infrastructure. To give you an example of such an enterprise, let’s take a step back in history and look at one of the oldest sector in the United States: the railroads. In 1920, the United States had the world’s most extensive rail network with nearly 1.3 billion passenger traffic. It was widely used for transporting people: each passenger generated $2.76 in revenue per mile, the equivalent of $40.90 today, about what Facebook (Meta Inc.) made per user in 2021.
But what happens when growth stagnates? For railroads, the decline began with the introduction of the Adamson Act in 1916, which reduced the work day of railroad workers from ten to eight hours per day. A year later, the US joined WWI, and President Wilson nationalized the railroad. By the time the industry was returned to private control in 1920, the Federal government had already established a regulatory agency controlling fare prices and a collective bargaining system for workers. By 1929, railroad companies began to envision a gloomy future as automobiles handled 5x the passenger miles carried by trains.
Fast forward a hundred years, and railroads are now primarily used for bulk freight transportation. Passenger freights make up only 0.05% of their operations revenue.
Railways can be an efficient mode of transportation due to their ability to carry a large amount of tonnage per trip and cheaper costs.
- A train can carry much more weight than a truck as the average train can carry the same load as roughly 400 trucks.
- Trains are also cheaper on a per-ton basis. For example, transporting the same goods from Texas to Ohio would be 3x cheaper on trains than on trucks.
This means trains are a cheap way to transport heavy and dense commodities. But that benefit comes with a trade-off. The lower price that trains offer comes at the cost of speed and flexibility.
Despite the benefits of railroad transportation, trucks still maintain 45.4% of the market share in freight transportation (see Figure 4 above). The key advantage that trucks have is flexibility:
- Trucks are available wherever there are roads
- They can deliver at specific times designated by the customer
- Trains move according to a preplanned schedule whereas truck routes and timelines can be customized.
Regardless, 26.9% of freight still travels via the railroad. Let’s deep diver and discuss the business of railroads by delving into one of the oldest companies in the sector.
Union Pacific
Established in 1862, the story of Union Pacific (UNP) mirrors that of the railway industry. As part of the first rail network that connected the contiguous US states, Union Pacific built 1,085 miles of railway that stretched through the western part of the United States (specifically Iowa, Omaha, and Nebraska). Following a wave of bankruptcies within the industry that began in the 1950s, Union Pacific acquired five of its competitors. By the early 90s, only a few major railway companies remained. Along with BNSF (a railroad company owned by Warren Buffett’s Berkshire Hathaway), Union Pacific had established a duopoly in the western half of the United States.
Although Union Pacific is only competing with one other major provider, it’s facing significant headwinds in its businesses (flat revenue and an unhappy workforce). Figure 5 below shows the company’s revenue growth compared to the S&P 500 year-over-year sales growth rate.
But why is it that in the last five years, its stock price has outperformed the S&P 500 index by 2x on average (see Figure 6 below), even though the volume of rail shipments has decreased by 9%?
Bad Business but Good Investment?
Despite being in a mature industry that has faced adverse headwinds over the past decade, Union Pacific has generated an above-average return. This is because the company has accomplished two things: (i) increased efficiency and (ii) becoming a monopoly.
Increased Efficiency
The company has been relentless in improving efficiency. This effort generally came in two forms:
- Getting more output from a smaller labor pool: Over the last five years, Union Pacific’s workforce has steadily declined, dropping from 42,919 employees in 2016 to 29,905 in 2021, a 30% decrease. This is the result of what the company refers to as ‘Precision Scheduled Railroading (PSR)’. PSR is an operating policy that requires workers to cover larger territories, do fewer safety inspections, run more cars per train, and work longer hours. The primary objective of PSR is to increase Operating Margins (see Figure 7). Its implementation resulted in a 23% decrease in the average time freights spent idling.
- Technological improvements: The company put cameras and IoT sensors on its trains’ tracks and wheels. The additional sensors provide real-time analytics, allowing the company to generate real-time insights to run more efficiently, perform preventative maintenance, and avoid accidents. This alleviates some pressure on workers and improves safety.
The constant cost reduction efforts are paying off. In the past five years, Union Pacific’s operating margin grew from 37% in 2017 to 43% in 2021 (see Figure 7 below).
However, these efficiency improvements have come with costs. Railway workers have criticized labor shortage and have been bargaining for higher wages for the past two years, and have even threatened to strike. As a result, major freight railroads backed plans for a 24% wage increase. Tha
t said, despite being the largest pay increase in the last 40 years, the amount is still significantly less than what the workers demanded (additional bonuses and insurance). Nevertheless, railroad workers were forced to accept the deal, as they did not have bargaining power. As railway transportation is deemed critical to the national interest, the US Congress can unilaterally end railway strikes. As former US President George HW Bush put it:
“It ought to end the day it begins.” — President George HW Bush
Being a monopoly
Additionally, railways typically enjoy the benefits of being a geographical monopoly. High costs and long lead times of getting permits and completing environmental reviews, laying tracks, and high capital expenditure for trains serve as barriers for new entrants. Compared to other rail companies, Union Pacific has a geographical advantage in the western US (Colorado, Utah, Wyoming, Kansas, and Nevada). This means the company has pricing power, which translates to superior profit margins. Compared to the average trucking company (such as FedEx), with margins around ~4%, UNP has consistently increased its margins from 21% in 2016 to 29% in 2022 (see Figure 8 below).
What to do with all that cash?
So, we have a mature business in UNP that improved its margins by increasing efficiency. By executing this strategy, Union Pacific has generated extra cash. The company has grown its free cash flow at a rate of 10% CAGR in the past five years. So what did they do with all this cash? Since the company is not building any new major railroads and not passing along the extra profits to its employees, it returned the extra cash to its shareholders.
In the past five years, Union Pacific spent $5.8 billion in share buybacks and $2 billion in dividends per year on average. In 2021, the company returned 41% of free cash flow to shareholders via buybacks and dividends. Despite its lack of prospects for future growth and inability to meet customer expectations, this high rate of return is something that investors recognize and appreciate.
