Eastern Railroad Discussion > Why would a railroad buy back stock instead of investing in track

Barron's investment magazine has a short piece today, arguing that many capital intensive businesses (railroads, telecoms, utilities, etc) spend too much money buying back stock, and too little money investing in plant and equipment.  The subject has received a lot of attention following the trillion dollar gift from the tax bill.  many firms used proceeds from the tax bill to buy back stock at much higher than current prices.  In Apple's case, about $10 billion dollars difference.

(Buying back stock involves a firm using company money to buy back stock from current share owners. This reduces the number of shares outstanding even when options are converted to new shares, and raises the earnings per ((remaining)) shares.  Which pleases Wall Street and the remaining owners.)

In the railroad's case, the mprovements could allow more trains to use the tracks and yards. Fewer repairs as newer locomotives perform, better training for better paid crews and signal systems, etc.  But this requires more selling of services, wooing new customers, etc.  Many railroads seem OK with lightly to moderately used tracks. Even the tax act's encouragement of new investment has had just a muted impact on new rail construction and equipment purchases.

The writer asserts that many firms use a cost of equity capital to decide whether it's worth investing in the plant. That's too  high a bar, he says, because most companies use a lot of debt and only a small amount of equity capital / stock.  Not unlike buying a $400,000 house with $80,000 of cash and $420,000 or mortgage.  You blend the cost of the housing, and don't consider just your possible future earnings on the $80,000.

Whether this analysis holds up as interest rates rise is anyone's guess.  Cheap money for the past ten years has distorted a lot of decision making.

Excerpt:Companies usually use “cost of equity capital” — the required rate of return that stockholders demand to compensate for the market risk — as a benchmark to assess whether a new capital investment is worth it. Investment opportunities that don’t top that bar are usually considered unfeasible, so the money goes to buybacks and dividends as a way to return excess cash to shareholders.But there is a good chance that the rate of return companies are using is too high, claims DataTrek’s Nicholas Colas. The average chief financial officer would likely set the cost of equity capital at around 10%, a high bar to reach, Colas writes. The actual cost is probably close to 5%, which would allow CFO’s to be more aggressive in their capex investment decisions. And that miscalculation comes with a cost. “Rather than invest in marginal projects, they try to buttress their stock’s valuation with buybacks,” writes Colas, “That’s a sensible approach in a micro sense, but markets see a macro environment where companies forsake long-term growth for short-term stock returns.

Because buying back stock increases the value of the remaining stock, and stock represents a big part of the higher-ups's compensation? Maybe it doesn't work that way.

I wish they would buy it ALL back, take the companies private and freeze out Wall Street altogether.  I  am sick and tired of people who own a rather inconsequential portion of a company inserting themselves into the management of a business they likely know nothing about.  I say this as someone who reluctantly has 90% of his retirement nest egg in stocks and bonds, but Henry Ford wasn't too far off when described stock holders as parasites.

junctiontower Wrote:
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> I wish they would buy it ALL back, take the
> companies private and freeze out Wall Street
> altogether.  I  am sick and tired of people who
> own a rather inconsequential portion of a company
> inserting themselves into the management of a
> business they likely know nothing about.  I say
> this as someone who reluctantly has 90% of his
> retirement nest egg in stocks and bonds, but Henry
> Ford wasn't too far off when described stock
> holders as parasites.

I like it......

Henry Ford actually practiced what he preached. As a private company, F ignored Wall Street, used ago of government loans, and treated his employees like slaves.

Look up Harry Bennett if you're interested in corporate thuggery.

Posted from Android

I've been studying the Fords for over 30 years.  Henry Ford was wrong about LOTS of things, but he was also right about a lot too. He was an inarticulate dunce, an anti-semite and an all around SOB much of the time, bbut he was also a simple minded genius who had some great instincts when he was functioning in his own element and tended not to overcomplicate things.  How he got rid of his minority stockholders was pure robber baron, BUT, his desire to control Ford Motor 100% was right on, and if it weren't for the inheritence tax , it STILL might be privately held.

The simple answer is, there's a point at which continuing to invest in track becomes pointless. The track has to be just good enough for the business it carries. This was an issue in the late 1950s when Champion McDowell Davis was finally kicked out of the president's office at ACL. The board decided that he was spending too much money on the railroad... an unnecessary amount of money. 

 

Right on the recent posts. You can either shrink into the railroad shape you want, or invest into a bigger organization, and hustle more business.

Few companies have shrunk into prosperity, but many have grown into it.

Posted from Android

As a former NS stock holder,I can say I don’t like the the upside on any of the rails at this point in time,barring any merger/takeover news.They are all going to PSR,which in theory chases away “marginal” business to focus on the “profitable”. The advent of self driving vehicles and other technological advances and the continuing downturn in coal has to make one wonder about the siphoning off of that “profitable” business and of the avenues of growth ahead, and of the ability of current RR management to deal with it.Currently it’s all about cutting to more profitability. To me,that can only work for so long,and I think the market priced most of that in with the last run up in price this past spring/summer when the news about UP being forced to adopt PSR came out. I sold all my RR stocks after the third quarter earning were released after an almost 150% gain since the 2016 election,and went to cash. I’m not against getting back in if prices drop further to a more attractive level,but even with the prices where they currently are after the downturn,they are still too high IMHO. 

   Tom

RRing is a cyclical business and much of the smart money seems to be saying that the current economic cycle has run its course. It wouldn't surprise me if RRs begin to see downturns in traffic, regardless of PSR. 

ctillnc Wrote:
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> RRing is a cyclical business and much of the smart
> money seems to be saying that the current economic
> cycle has run its course. It wouldn't surprise me
> if RRs begin to see downturns in traffic,
> regardless of PSR. 

When it comes to the Wall St universe........so- called smart money is an oxymoron.  Many adjectives can be applied to Wall St, but "smart" is not applicable.  

AA

Stanford White
Carmel Valley, CA

Well, they're making the millions. Most likely, you and I aren't. At the end of the day, ask yourself, who's smart. 

I wouldn't put to much stock in that Barron's article. The idea of using the cost of equity as the cost of capital goes against everything that is taught from Finance 101 on up, and there is a very rich literature spanning many decades addressing various issues surrounding the cost of capital.

This Barron's article was written by a millennial job-hopper with no education or experience in finance (look up Evie Liu's profile on LinkedIn like I did); she cites only two sources for her assertions--and I'll bet she quoted them out of context.

That's not to say that the finance and accounting departments of the railroads have their priorities straight, but I doubt very much that they are using the cost of equity as their cost of capital when making decisions.