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One of the best ways to learn how to invest is to study successful investors and their investment decisions . One investor whose portfolio I like to keep a close eye on is billionaire Bill Ackman. He manages one of the most closely watched portfolios in the financial world. This portfolio includes great companies like Hilton, Lowe's, Netflix, Chipotle, and Domino's.
He recently added another company to that portfolio worth $1.2 billion. This investment can be called a classic Bill Ackman investment. This is due to the attractive characteristics of the business, as well as the fact that Ackman already owned these shares before. In this video, we'll see how this investment fits into the checklist Ackman uses to evaluate potential investments.
Be sure to watch this video to the end, because Ackman's checklist is something you can start applying to your own investment process today. Without wasting any time, let's start the video. Ackman recently announced that his hedge fund Pershing Square owns a stake of about 14.8 million shares of Canadian Pacific, worth $1.2 billion.
For reference: Canadian Pacific is a railway company operating throughout Canada. The company is currently seeking government approval to complete its planned acquisition of another railroad—Kansas City Southern. If this deal is completed, Canadian Pacific will become the first railroad with a network spanning three major North American countries: Canada, the United States, and Mexico.
So, with that understanding, let's move on to the most interesting part of the video. Let's take a look at Bill Ackman's investment checklist and see how this investment fits into it. Ackman was extremely candid in outlining his investment criteria. This checklist contains five items . For Ackman to consider investing, the company must be: first, simple, second, predictable, third, generate cash flow, and fourth, have a powerful "moat," that is, a significant competitive advantage.
And fifth: the shares should be sold at a discount. Regarding the first point: in the world of stocks, business could hardly be simpler than railroading. Railway companies run a fairly straightforward business. They charge companies to transport freight on their network of railroad tracks and rail cars.
In an increasingly technology-driven world of public companies , I would say that railroads fall into the category of relatively easy-to- understand businesses. Simply put, a railroad's revenue is based on two things. The volume of freight transported by rail and the price the railway charges customers for the transportation.
Revenue tonne miles are the most widely- watched volume metric in the industry. Revenue ton-miles are calculated by multiplying the weight of the cargo in tons by the number of miles it is transported. To understand how railroads work, you need to know what metric investors consider most important in the industry.
This indicator is called the operating ratio. The operating ratio is calculated by dividing a company's operating expenses, such as employee wages, by its revenue. So, if a company, for example, had $80 in expenses and $100 in revenue, its operating ratio would be 80%. The reason why the operating ratio is so important to railroads is that it helps investors assess the efficiency of the railroad's operations.
The lower the operating ratio, the better . A lower operating ratio is better because it means the company spent less money to generate $1 in revenue. So, the lower the operating ratio, the more profitable the railway is. In 2021, Canadian Pacific's adjusted operating ratio was 57.6%. By comparison, BNSF, the railroad owned by legendary investor Warren Buffett through his company Berkshire Hathaway, had an operating ratio of 60.9% in 2021.
Canadian Pacific's operating ratio is currently the best in the industry. However, this wasn't always the case, and this improvement is actually a result of Bill Ackman's previous investments in the company. Previously, Canadian Pacific's operating ratio was at 80%, and the company was considered inefficient.
In the early 2010s, Bill Ackman made a large investment in the company as part of so- called activist investing, when an investor buys a large stake in a company that he believes is poorly managed by the current management team. They then try to make changes that make the company more profitable and make money from the rising stock price.
Thanks to Ackman's investment in Canadian Pacific, he was able to replace the CEO with someone who had experience improving the efficiency of railways. In short , Canadian Pacific has become much more efficient. Profitability improved and the share price rose. Canadian Pacific shares rose 180% from when Ackman first purchased his stake in 2011 until his exit in 2016, netting the investor about $2.6 billion in profits.
It's clear that a lot of research went into creating this video , as I studied Canadian Pacific and the industry to provide you with quality content. This research has been made much easier thanks to Quarter, the sponsor of today's video . I approached Quarter about sponsoring this video because it streamlines the investment research process and should become a basic tool for every fundamental investor.
I was able to review transcripts of Canadian Pacific's earnings reports, learn what Wall Street analysts were saying about the company, and access investor presentations. The best part about the app is that it is completely free . Download the program from the link in the description . The next item on Ackman's checklist is business predictability.
Predictability means that you can reasonably predict a company's performance for the next 5 or even 10 years. To better illustrate this, I think it would be helpful to think of predictability as a spectrum. At one end are businesses where it is extremely difficult, if not impossible, to predict how the company will perform even next year, let alone 5 or 10 years in the future.
At this end of the spectrum, think of a movie studio. In the case of a film studio, this is largely a so- called hit-based business. This means that if you release a hit movie in a year, you can make extraordinary profits. But if your film fails, it will be a tough year in terms of financial results for the business.
As you can imagine, it is very difficult to assess how a company will perform in the coming years, so predictability is low here. At the other end of the spectrum are extremely predictable businesses. Think about apartment building owners. You know that on average, rents are likely to increase by 2–4% per year.
While no business knows exactly how profitable it will be in 5 years, apartment building owners can usually have a pretty good guess about what rents will be in 5 or even 10 years. As for Canadian Pacific, I would argue that it leans more towards the predictable end of the spectrum. Revenue has remained relatively stable over the past few years.
$7.99 billion in 2021, $7.71 billion in 2020, and $7.79 billion in 2019. Even in the worst year of the Great Financial Crisis in the late 2000s, revenue fell by only 10%. The next part of Ackman's checklist is that the company must generate cash. The metric we're looking at here is free cash flow. For those of you who may not be familiar with the term, free cash flow is calculated by subtracting capital expenditures from a company's operating cash flow .
Capital expenditures, or CapEx for short, are the funds a company spends to purchase physical assets, such as real estate, equipment, and vehicles, used in business operations. So, in the case of railways, capital expenditures are the purchase of locomotives and cars or the replacement and renovation of the tracks on which trains run.
If we look at Canadian Pacific, we see that in 2021 the company received $3,688 million in cash flow from operating activities. By the way, all these numbers are in millions. That same year, they also spent $1,532 million on capital expenditures. This means that Canadian Pacific generated nearly $2.2 billion in free cash flow in 2021.
Performing the same calculations— subtracting capital expenditures from cash flow from operating activities— we see that Canadian Pacific's free cash flow in 2020 was $1.1 billion. In 2019, this free cash flow figure was approaching $1.4 billion. Ultimately, this is the most important metric for evaluating a business.
This is because the value of any investment is based on the cash flow that investment is able to generate for you as an investor. Additionally, when companies generate a lot of free cash flow, they can do great things for you as an investor. This includes paying down the company's debts, possibly buying a smaller company, or paying dividends and buying back shares.
All of this can be very beneficial for you as an investor. If you want to learn more about how to analyze a company's cash flow statement, you can watch a video I made about it here. Also, if you want to see the spreadsheet I used to analyze the company's cash flow, you can access it through my Patreon using the link in the description.
There I publish all the tools that I personally use to analyze stocks. So, now we've established that free cash flow is important, but what's stopping another company from entering the market and taking the profitability away from the company you're analyzing? The answer to this question is what is called in investing the “ economic moat,” and it is the next item on Ackman’s checklist.
A moat, also called a competitive advantage, is how a company protects itself from competitors. There are two types of ditches for railways: the advantage of low cost and the difficulty of reproduction. Regarding the low- cost advantage, it is much cheaper for companies to transport their goods over long distances by rail than by other modes of transport such as trucks or planes.
The advantage of low costs is one of the most well-known types of trenches, which is applied to many different industries. Think Walmart for American retail or Toyota when it comes to cars. One of the best ways for a business to differentiate itself from its competitors is to be able to offer customers lower prices than other companies.
Another type of “ economic moat” that is very characteristic of railways is the difficulty of reproduction. The railway industry is perhaps the only one where it is virtually impossible for a new company to start operations from scratch. Thousands and thousands of miles of railroad tracks in North America were built over nearly 200 years.
To operate a railroad effectively, you need to have thousands of miles of track stretching across a significant portion of the country. If someone today tried to build a competing railroad from scratch , it would take years and probably tens of billions of dollars to create such a network. And this is without taking into account obtaining state permits for laying tracks.
This concept of the difficulty of a new company entering an industry is called barriers to entry. Honestly, I can't think of any industry with higher barriers to entry than rail . So, even if a stock meets all the other points on Ekman's list, there is still one more important point that must be made before buying.
The last item on the list—the stock should be trading at a discount to its intrinsic value. To quote the greatest investor of all time, Warren Buffett: "No company, no matter how great, is worth an infinite price." There are probably plenty of companies that fit the other criteria on the list, but the secret to investing is to find stocks that are selling at a discount to their true value, or, in investor parlance, their intrinsic value .
This is perhaps one of the most challenging aspects of investing, especially in a period of relatively high stock prices like today. Buying stocks at a price below their intrinsic value is a key pillar of Ekman's investment style. Let's take Canadian Pacific stock as an example . At the time of this video, Canadian Pacific shares are trading at approximately $75 a share.
For example, let's assume that according to Ekman's analysis, the real value of a stock is $100 per share. The difference between the intrinsic value of the stock—$100—and the price the investor pays—in this case, $75—is the investor's "margin of safety." The greater the safety margin, the better, all other things being equal.
Let's assume that Ekman was wrong in his estimate of Canadian Pacific's intrinsic value or that the company is not performing as he expected. Having a safety margin when investing would have protected Ekman from losing money. Suppose instead of an intrinsic value of $100 per share, the analysis turned out to be incorrect, and in fact the intrinsic value was 20% lower, i.e.
$80 per share. If that were the case, even if Ekman had made a 20% error in estimating the value of Canadian Pacific, he still wouldn't have lost money because he had a margin of safety. If you enjoyed this video about Ekman's investment in Canadian Pacific, be sure to check out my recent video about Ekman's other billion-dollar bet on the company here .
I hope you enjoyed this video. Be sure to give this video a big like and subscribe to Investor Center, because my goal is to make you better investors by studying the experience of the world's most prominent investors. See you next time.
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