Bill Ackman's New Stock for 2022
One of the best ways to learn about investing is to study great investors and the investments that they make. One investor whose portfolio I like to follow closely is billionaire Bill Ackman. He runs one of the most closely followed portfolios in all of finance. This portfolio includes great companies such as Hilton, Lowe's, Netflix, Chipotle, and Domino's. He recently added another company to that portfolio to the tune of $1.2 billion. This investment can only be described as a classic Bill Ackman investment. This is because of the attractive characteristics of the business, but also because this actually isn't the first time Ackman has owned the stock.
In this video, we're going to see how this investment stacks up against Ackman's checklist he uses to evaluate a potential investment. Make sure to stick around to the end of this video because Ackman's investment checklist is something that you can start applying to your own investment research process today. Without further ado, let's jump into the video.
Ackman recently announced that his hedge fund, Pershing Square, has a stake of around 14.8 million shares of the company Canadian Pacific, worth $1.2 billion dollars. Just as some background, Canadian Pacific is a railroad with operations throughout the country of Canada. The company is in the process of trying to receive approval from government agencies in order to complete its proposed acquisition of another railroad, Kansas City Southern. If this deal is completed, it will result in Canadian Pacific being the first railroad with a network that goes through three major countries in North America: Canada, the United States, and Mexico.
So now that we have that background, let's get into the real fun part of this video: looking at Bill Ackman's investing checklist and seeing how this investment stacks up. Ackman has been extremely straightforward with laying out his investment criteria. This checklist has five points. In order for Ackman to consider investing, a company needs to be: one, simple; two, predictable; three, cash flow generative; four, have a strong moat, also known as a strong competitive advantage; and five, the stock must be selling for a discount.
On the first point, in the world of stocks, a business honestly doesn't get much simpler than a railroad. Railroad companies operate a pretty straightforward business. They charge companies for carrying cargo over their network of rails and rail cars. In the world of publicly traded companies, which is increasingly becoming more technology-focused, I would say that railroads fall into the category of being relatively simple businesses to understand.
Put simply, a railroad's sales are based on two things: the volume of cargo being shipped on the railroad and the price the railroad charges customers to ship on the railroad. Revenue ton miles is the most looked at measure for volume in the industry. Revenue ton miles is calculated by multiplying the shipment's weight in tons by the number of miles that is transported.
In order to understand how railroads work, you have to understand what money investors consider to be the most important metric in the industry. This metric is what is referred to as operating ratio. The operating ratio is calculated by taking the company's operating expenses—so think of expenses such as employee wages—and then dividing that by the company's revenue. So if a company, for example, had eighty dollars in expenses and one hundred dollars in revenue, its operating ratio would be 80 percent.
The reason operating ratio is so important for railroads is that it helps investors evaluate how efficient the railroad's operations are. The lower the operating ratio, the better. The reason a lower operating ratio is better is because that means the company incurred less cost to produce one dollar of revenue. So, the lower the operating ratio, the more profitable the railroad is.
In 2021, Canadian Pacific's adjusted operating ratio was 57.6. Just for some perspective, BNSF, which is the railroad legendary investor Warren Buffett owns through his company Berkshire Hathaway, had an operating ratio of 60.9 in 2021. Canadian Pacific's operating ratio is now best in class for the industry. However, this wasn't always the case, and this improvement is actually a result of Bill Ackman's previous investment in the company.
Canadian Pacific used to have an operating ratio in the 80s, and it was viewed as an inefficient company. In the early 2010s, Bill Ackman made a large investment in the company in what is referred to as an activist investment, where an investor takes a large stake in a company that they believe is being run poorly by the current management team. They then try to make changes that make the company more profitable and make money as the stock price increases.
With Ackman's investment in Canadian Pacific, he was able to replace the CEO with someone who had experience making railroads more efficient. Long story short, Canadian Pacific became much more efficient, profitability improved, and the stock price went up. Canadian Pacific shares gained 180 percent from when Ackman first took his stake in 2011 to his exit in 2016, and earned the investor a profit of about $2.6 billion dollars.
Obviously, a ton of research went into this video as I was learning about Canadian Pacific in the industry in order to provide you guys with quality content. That research was made way easier because of Quarter, the sponsor of today's video. I reached out to Quarter to sponsor this video as it streamlines the investment research process and should be a foundational tool for any fundamental investor.
I was able to read through earnings call transcripts for Canadian Pacific and see what Wall Street analysts were saying about the company, as well as gain access to investor presentations on the company. The best part of the app is that it's completely free. Download the app at the link in the description.
Next up on Ackman's checklist is whether the business is predictable. By predictable, it means you can reasonably predict how the company will perform over the next five or even ten years. To better illustrate this, I think it would be helpful to think of predictability on a spectrum. On one end, you have businesses where it is incredibly difficult, if not downright impossible, to predict how the company will perform even next year, let alone five or ten years down the road.
On this end of the spectrum, think about a movie production company. With a movie production company, it is very much what is referred to as a hits-driven business. Meaning if you have a hit movie you release in a year, you can be extremely profitable, but if your movie release flops, it's going to be a rough year in terms of the business's financial performance. As you can imagine, it is very hard to evaluate how the company is going to perform in future years, and predictability is low.
On the other end of the spectrum, you have extremely predictable businesses. Think about owners of apartment buildings. You know, on average, rents are likely to grow two to four percent a year. While no business knows exactly how profitable it will be five years from now, apartment building owners can usually have a somewhat reasonable assumption of what rents will look like five or even ten years from now.
When it comes to Canadian Pacific, I would make the argument that it falls more towards the predictable end of the spectrum. Revenue has been relatively consistent over the past few years: $7.99 billion dollars in 2021, $7.71 billion dollars in 2020, and $7.79 billion dollars in 2019. Even dating back to the worst year of the Great Financial Crisis of the late 2000s, revenue only fell by 10 percent.
The next part of Ackman's checklist is that the company needs to generate cash. The metric we look at here is free cash flow. For those of you who may not be familiar, free cash flow is calculated by taking the company's cash from operations and subtracting out capital expenditures. Capital expenditures, or capex for short, is money the company spends to acquire physical things, such as real estate, equipment, and vehicles that are used in the operations of the business.
So, in the case of a railroad, capital expenditures are things like buying locomotives and rail cars or replacing and updating the tracks that the trains run on. So if we look at Canadian Pacific, we see that in 2021 the company had $3,688 million dollars in cash from operations. All of these numbers are millions, by the way. In the year, they also spent $1,532 million on capex. This means that for 2021, Canadian Pacific did nearly $2.2 billion dollars in free cash flow.
Doing the same math of taking the cash from operations and subtracting out capex, we see that in 2020 Canadian Pacific did $1.1 billion dollars in free cash flow. For 2019, that free cash flow number was pushing up against $1.4 billion dollars. At the end of the day, it's the most important metric in 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 ton of free cash flow, they are able to do great things for you as an investor. That includes paying back debt the company has, maybe buying a smaller company, or paying dividends and buying back stock—all things that could be very good for you as an investor. If you want to learn more about how to analyze a company's cash flow statement, you can check out the video I made on it here.
Also, if you want to see the spreadsheet I used to analyze a company's cash flow, you can access that through my Patreon at the link in the description. That's where I post all the tools I personally use to analyze stocks.
So now we have established that free cash flow is important, but what stops another company from entering the industry and taking away the profitability of the company you are analyzing? The answer to this question is what is referred to in investing as a moat, and that's next on Ackman's checklist.
A moat, which is also referred to as a competitive advantage, is how a company protects itself from competitors. There are two moats when it comes to railroads: low cost advantage and difficulty to replicate. In terms of the low cost advantage, it is much cheaper for companies to move their goods via rail long distances than other forms of transportation, such as trucks and airplanes. Low cost advantage is one of the most well-known types of moats and applies to many different industries. Think of Walmart for American retail or Toyota when it comes to vehicles.
One of the best ways for businesses to keep competitors away is by being able to charge customers less than other companies. The other type of moat that is very apparent for railroads is difficulty to replicate. The railroad industry may be literally one of the only industries where it is essentially impossible for a new company to enter the industry from scratch. The thousands and thousands of miles of train tracks through North America took nearly 200 years to build.
In order to operate a railroad effectively, you have to have thousands of miles of track stretching across a large portion of the country. If the company was starting from scratch today and attempting to build a competing railroad, it would take years and likely tens of billions of dollars to build out a network of tracks. That doesn't even account for getting government approval to build those tracks.
This concept of the difficulty associated with a new company entering an industry is referred to as barriers to entry. I honestly can't think of any industry with higher barriers to entry than that of a railroad. So even if a stock meets all the other items on Ackman's checklist, there is still one last important item that needs to be met before Ackman would buy a stock.
That last item on the checklist is that the stock needs to be trading for a discount relative to its intrinsic value. To quote the greatest investor of all time, Warren Buffett: "No company, no matter how wonderful, is worth an infinite price." There's likely a ton of companies that meet all the other criteria on the checklist. But the secret to investing is being able to find the stocks that are selling at a discount to their true value, or to put it in investing lingo, their intrinsic value.
This is also probably one of the most challenging aspects of investing, especially during a period of relatively high stock prices like we are in today. Buying a stock for less than its intrinsic value is a core pillar of Ackman's style of investing. Let's use Canadian Pacific stock as an example. As of the making of this video, Canadian Pacific stock is trading around $75 per share.
Let's see, for the sake of this example, that based on Ackman's analysis, he believes the true value of the stock is $100 per share. The difference between the intrinsic value of the stock, the $100, and what an investor pays, in this case, $75 per share, represents an investor's margin of safety. The larger the margin of safety, the better. All else being equal, let's say that Ackman is wrong about his estimate of Canadian Pacific's intrinsic value, or that the company doesn't perform the way Ackman believed it would.
By having a margin of safety when investing, this would protect Ackman from losing money. Let's say that instead of the intrinsic value being $100 per share, let's say that the analysis was incorrect, and instead, each year’s intrinsic value is actually twenty percent less, or $80 per share. If this was the case, even though Ackman was off by 20 percent in his estimate of Canadian Pacific's value, he still didn't lose money because he had a margin of safety.
If you enjoyed this video on Ackman's investment in Canadian Pacific, make sure to check out this video I did not too long ago on another billion-dollar bet Ackman made on a different company. Here, I hope you guys enjoyed this video. Make sure to give this video a big like and subscribe to the Investor Center, because it is my goal to make you a better investor by studying the world's greatest investors. Talk to you next time.