A Short Story About Investing in FreightCar America (NASDAQ:RAIL)

[VAL9000]

This post is a story about how I developed an investment thesis, committed to it, came across new information, and abandoned it over the course of nine months.

 

At the start of the year I had a lot of free time.  I decided that it would be good for me to use this time to come up with my own investment idea.  Normally I find ideas from other people's initial analysis and promotion, but I wanted to "Be Like Buffett" and come up with my own.  I pulled a lot of data, looked at a lot of small caps, and eventually learned about FreightCar America (NASDAQ:RAIL).

 

I was attracted to RAIL initially because it seemed like it was being overlooked in terms of long-term earnings potential.  They had been making losses for a while and US manufacturing was heavily out of favour at the time.  Overall their metrics were good, with a low average P/E (over 6-7 years) in the high singles depending on how you counted, a reasonable price/book of <2.0, and no debt.  I computed the numbers backwards and forwards and thought that they'd see about $60-$70 in share price over the next three years as rail car demand increased.

 

The company had been struggling under a CEO whose main focus was internal change, including cost reduction and management strategies.  What RAIL was clearly missing was sales.  Orders were down to their lowest levels in reported history.  Much of this was due to the broader market, but I thought that the replacement CEO was also indicative.  The former head of sales, Ed Whalen, was brought out of retirement to run the company.  I took this as a good sign.  RAIL had consolidated its manufacturing operations and reduced its SG&A during the downturn.

 

In terms of industry structure, rail car manufacturing is compelling.  There are five competitors in NA, and it's expensive to ship these overseas because they can't be containerized.  RAIL is narrowly focused on coal car manufacturing, and captures about 80-90% of the market in any given year.  At the time, coal was also very interesting to me.  I had researched a number of coal companies as well, which I missed the boat on.  I thought that RAIL was overlooked as an obvious beneficiary of rising coal demand.

 

I also came across some really positive market data that was further reinforcing the idea that RAIL would be a cash cow over the next 3-5 years:

- Rail car orders over the past 5 years were at all time lows, while rail loadings were up

- Coal demand was again rising as coal burning power plant inventories began to come down

- Steel price was up, which would increase scrapping of old steel coal cars (modern cars are made of aluminum)

- Unused rail car inventory was steadily dropping

 

I invested at $28.89 in February.  Not a huge investment, but enough for me to pay attention to.

 

Over the coming six months, my thesis began to play out.  Orders increased, car loadings were up, and train speeds were starting to come down.  An interesting fact that I learned during my study is that rail car demand accelerates as the rail network becomes busy both because of natural demand and because a busier system is a slower system.  A slower system requires more product in transit to meet the natural demand.  Neat huh?

 

In the face of all this good news, RAIL dropped in August with the broad market.  I roughly tripled my position at $16.34.

 

I ended up selling in mid-November at $24.01 for a gain of 22.13%.  I think I got lucky, and here's why:

 

Around this time I began to learn more about the future of coal.  Currently, coal is used to meet almost half of the US's electricity needs.  The underlying demand theory I was working with was that coal would continue to play an important role in the future of energy for the next 30+ years.  I don't think this is true any longer.  There are two major alternatives to coal: natural gas and solar power.  Natural gas price has dropped considerably, and many modern power plants are equipped to burn both coal and nat gas.  Based on the shale discoveries and environmental concerns, I see increased preference to burning natural gas in place of coal at many of these plants.  The other competitor, solar power, was illustrated to me in this article:

http://www.bloomberg.com/news/2011-11-08/solar-shakeout-could-soon-reach-china.html

 

Note the timing of my exit vs. the timing of this article.  The logic that caused me to abandon my investment was that between solar power and natural gas, coal demand will begin to drop in the US for the foreseeable future.  Coal cars last about 30 years.  I can't see how anybody would be willing to invest heavily new coal cars over the next five years when the thirty year lifespan of those cars will probably not be required.  RAIL's business is 80-90% based on demand for coal cars.  This just isn't a good place to be invested given the chain of demand.

 

And so, I got out.  I loved this process and I can't complain about the result.  The best outcomes were:

- I learned that I could take the plunge on my own idea, which adds to my confidence in investing and gives me more freedom in choosing investments in the future.

- I learned a ton about the rail business, the coal business, and some about the energy business.

- It was a successful endeavour.  I consider this bit pure luck because the information around solar power and natural gas was readily available back in February.

- I abandoned an investment that I had an emotional tie to (my first baby, if you will), which is a good sign for maintaining objectivity.

 

The thing I regret the most is that I didn't post this idea to the board when I was researching it.  I was new to the board, I didn't think I could handle the criticism, and since this was my first foray into deep analysis I didn't want to be driven off track by external opinions.  Stupid move, though.  For future research projects I will be presenting before or shortly-after investing.

 

- VAL

[beerbaron]

Thanks for sharing your experience.

 

BeerBaron

[augustabound]

Nice write up and thanks for sharing it. 

I think I said it in another thread a while back, but it's nice to see honest and objective analysis like this. 

 

FWIW, I totally hear you about sharing an investment thesis when you're a newer member to a group of more experience investors (I'm on the novice end compared to other members here).  But, if you're going to do it anywhere online and get an objective, respectful and constructive criticism, it's this board. 

[rranjan]

Good write up. I had followed RAIL in 2008/9 and discarded the idea ( I don't remember the reason for it right now). It was looking cheap then as well based on pent up demand for rail cars.

[twacowfca]

This post is a story about how I developed an investment thesis, committed to it, came across new information, and abandoned it over the course of nine months.

 

At the start of the year I had a lot of free time.  I decided that it would be good for me to use this time to come up with my own investment idea.  Normally I find ideas from other people's initial analysis and promotion, but I wanted to "Be Like Buffett" and come up with my own.  I pulled a lot of data, looked at a lot of small caps, and eventually learned about FreightCar America (NASDAQ:RAIL).

 

I was attracted to RAIL initially because it seemed like it was being overlooked in terms of long-term earnings potential.  They had been making losses for a while and US manufacturing was heavily out of favour at the time.  Overall their metrics were good, with a low average P/E (over 6-7 years) in the high singles depending on how you counted, a reasonable price/book of <2.0, and no debt.  I computed the numbers backwards and forwards and thought that they'd see about $60-$70 in share price over the next three years as rail car demand increased.

 

The company had been struggling under a CEO whose main focus was internal change, including cost reduction and management strategies.  What RAIL was clearly missing was sales.  Orders were down to their lowest levels in reported history.  Much of this was due to the broader market, but I thought that the replacement CEO was also indicative.  The former head of sales, Ed Whalen, was brought out of retirement to run the company.  I took this as a good sign.  RAIL had consolidated its manufacturing operations and reduced its SG&A during the downturn.

 

In terms of industry structure, rail car manufacturing is compelling.  There are five competitors in NA, and it's expensive to ship these overseas because they can't be containerized.  RAIL is narrowly focused on coal car manufacturing, and captures about 80-90% of the market in any given year.  At the time, coal was also very interesting to me.  I had researched a number of coal companies as well, which I missed the boat on.  I thought that RAIL was overlooked as an obvious beneficiary of rising coal demand.

 

I also came across some really positive market data that was further reinforcing the idea that RAIL would be a cash cow over the next 3-5 years:

- Rail car orders over the past 5 years were at all time lows, while rail loadings were up

- Coal demand was again rising as coal burning power plant inventories began to come down

- Steel price was up, which would increase scrapping of old steel coal cars (modern cars are made of aluminum)

- Unused rail car inventory was steadily dropping

 

I invested at $28.89 in February.  Not a huge investment, but enough for me to pay attention to.

 

Over the coming six months, my thesis began to play out.  Orders increased, car loadings were up, and train speeds were starting to come down.  An interesting fact that I learned during my study is that rail car demand accelerates as the rail network becomes busy both because of natural demand and because a busier system is a slower system.  A slower system requires more product in transit to meet the natural demand.  Neat huh?

 

In the face of all this good news, RAIL dropped in August with the broad market.  I roughly tripled my position at $16.34.

 

I ended up selling in mid-November at $24.01 for a gain of 22.13%.  I think I got lucky, and here's why:

 

Around this time I began to learn more about the future of coal.  Currently, coal is used to meet almost half of the US's electricity needs.  The underlying demand theory I was working with was that coal would continue to play an important role in the future of energy for the next 30+ years.  I don't think this is true any longer.  There are two major alternatives to coal: natural gas and solar power.  Natural gas price has dropped considerably, and many modern power plants are equipped to burn both coal and nat gas.  Based on the shale discoveries and environmental concerns, I see increased preference to burning natural gas in place of coal at many of these plants.  The other competitor, solar power, was illustrated to me in this article:

http://www.bloomberg.com/news/2011-11-08/solar-shakeout-could-soon-reach-china.html

 

Note the timing of my exit vs. the timing of this article.  The logic that caused me to abandon my investment was that between solar power and natural gas, coal demand will begin to drop in the US for the foreseeable future.  Coal cars last about 30 years.  I can't see how anybody would be willing to invest heavily new coal cars over the next five years when the thirty year lifespan of those cars will probably not be required.  RAIL's business is 80-90% based on demand for coal cars.  This just isn't a good place to be invested given the chain of demand.

 

And so, I got out.  I loved this process and I can't complain about the result.  The best outcomes were:

- I learned that I could take the plunge on my own idea, which adds to my confidence in investing and gives me more freedom in choosing investments in the future.

- I learned a ton about the rail business, the coal business, and some about the energy business.

- It was a successful endeavour.  I consider this bit pure luck because the information around solar power and natural gas was readily available back in February.

- I abandoned an investment that I had an emotional tie to (my first baby, if you will), which is a good sign for maintaining objectivity.

 

The thing I regret the most is that I didn't post this idea to the board when I was researching it.  I was new to the board, I didn't think I could handle the criticism, and since this was my first foray into deep analysis I didn't want to be driven off track by external opinions.  Stupid move, though.  For future research projects I will be presenting before or shortly-after investing.

 

- VAL

 

Val, I think you will do well.  The ability to sit back and objectively assess an investment as new information or better understanding developes is key to avoiding confirmation bias after a stock you picked goes up.  :)

[Kuhndan]

Great write up. I look forward to your next investment idea.

[eclecticvalue]

The thing I regret the most is that I didn't post this idea to the board when I was researching it.  I was new to the board, I didn't think I could handle the criticism, and since this was my first foray into deep analysis I didn't want to be driven off track by external opinions.  Stupid move, though.  For future research projects I will be presenting before or shortly-after investing.

 

- VAL

 

There is nothing to regret about by not posting the idea on the board. You are right to conclude "I didn't want to be driven off track by external opinions"

 

It happened to me on this board when discussion was going on about FBK and MERC earlier this year. People suggested FBK was better of the two. If I got into MERC I could've made 50%-60% returns in a month easily. Although MERC has come down quite a lot from 52 week highs. Luckily, I never invested in FBK and now it is in a complicated takeover situation.

 

Overall there are pros and cons posting on messageboards and in your case it worked out for you not posting.

[Liberty]

Thanks for sharing!