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Canadian investors’ love affair with rail keeps rolling

Buoyed by the latest stellar quarter, investors continue their love affair with Canadian railways. Both Canadian National Railway Co. and Canadian Railway Pacific Ltd. hit record highs, amid enthusiastic reports from analysts.

CN drew raves and analyst target upgrades after posting record volumes and beating profit forecasts. CP Rail won similar praise; the company's third quarter "far exceeds expectations, with more to come," exclaimed Benoit Poirier of Desjardins Securities, who somewhat belatedly upgraded the stock to a buy from a hold and raised his price target to $162.

CP was a chronic laggard before activist U.S. investor Bill Ackman lit a fire in the engine room. His hedge fund, Pershing Square Capital Management, cashed out nearly 30 per cent of its holding last June and revealed Thursday that it is selling another chunk of 5.9 million shares, worth about $800-million. But Mr. Ackman plainly sees more room for profit. His fund will retain a 9.8 per cent stake, remaining the biggest shareholder in the widely held railway.

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Not even a potentially embarrassing U.S. whistleblower lawsuit accusing CN of manipulating statistics to make it seem more efficient to customers than it really was is likely to slow this freight train. The legal action, filed in Memphis, Tenn., in August, stems from the firing of a local trainmaster for two CN subsidiaries. The rail giant contends the employee was dismissed for falsely reporting how long trains sat idle in the yard and that it would never condone such behaviour.

But leaving aside the unproved allegation of statistical improprieties, investors are still left with the vexing question of how much room Canada's rail heavyweights actually have to wring further costs out of their operations, while boosting volumes and goosing profits in a weak environment.

If it's true that railways remain proxies for the overall economy, where is all the excitement coming from? Both the U.S. and Canadian economies have stumbled, as Bank of Canada Governor Stephen Poloz made clear this week. Coal exports, a key driver of U.S. rail volume, have been falling.

Still, crude oil shipments are sure to remain a strong profit generator. Up to two million barrels a day will be moved by rail by the end of next year, according to one Canadian industry estimate. But a string of accidents have put a harsh spotlight on rail safety. At the very least, carriers will end up having to spend considerably more to meet regulators' concerns on both sides of the border. They'll likely be adding staff, upgrading tracks and monitoring capabilities and investing in new tank cars or retrofitting older ones to meet tougher standards. The U.S. National Transportation Safety Board estimated last year that more than two-thirds of the existing fleet carried "a high incidence of tank failure during accidents."

The efficient operators will be able to absorb the additional costs and continue chugging along, but a slower clip, particularly now that they have driven their operating ratios about as low as they can go. Still, they are bound to remain stock-market darlings as they morph into something Canadian investors have always adored: another way to play oil.

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About the Author
Senior Economics Writer and Global Markets Columnist

Brian Milner is a senior economics writer and global markets columnist. In a long career at The Globe and Mail, he has covered diverse business beats, including international trade, the automotive industry, media, debt markets, banking and the business side of sports. More

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