Have the Rail Stocks Been Derailed?

The past 4 years have been great for railway stocks. The boom in energy and exportation of resources since 2011 has seen revenues and profits soaring. Investors that participated in this story have been handsomely rewarded with stocks like Canadian Pacific Railway having risen 400% off of its 2011 lows.

While I do not want to question the quality of Canadian railway stocks, all investors must recognize that the easy money has already been made and what were cheap rail stocks in 2011 are now relatively fully priced stocks in 2015. While a stock being fully priced is not a concern in itself, we must factor in the fundamental shift in the macroeconomic environment.

So what has changed? Oil.

The Canadian economy is resource based and has benefited from the growing infrastructure projects associated with fracking and oil sand production. As production started increasing, oil producers increased their reliance on rail as pipelines failed to keep pace with the surge. Some suggest that this has been as much as a 40 fold increase in carloads in just 5 years.

The problem now lies in the fact that oil prices have collapsed. The heavy bitumen oil produced from the oil sands has been particularly hit hard having recently dropped below $30.00. While the companies have started to cut spending, the oil is still flowing. The risk really is dependent on how long oil is to remain at or below these levels. Production may have to be curtailed inevitably, impacting the pricing power and quantity of oil shipped.

The second problem lies in the recent derailment accidents. There is now increasing government scrutiny which will lead to tighter regulations and increased costs as many railcars will need to be upgraded.

The bottom line is that there is increasing risk. So should you sell your shares? You could. Should you buy a put option as protection? You also could, but the cost is considerable if you are going out for a longer duration. From my perspective, implementing a collar strategy makes the most sense as I believe there is still some upside (though limited).

Let me illustrate using Canadian Pacific Railway shares:

• investor has owned the CP shares for many years and has a considerable capital gain if the shares are sold
• The stock is trading at $229.24 (March 27^th, 2015)
• The collar is a combination of a protective put with a covered call. In this case we are buying the October $230.00 put for $17.50 or $1750.00 debit for every 100 shares.
• The investor then proceeds to sell an October $255.00 covered call for $7.50 or $750.00 credit.

The investor has now paid $10.00 or $1000.00 net for creating the collar.

What has the investor created?

The investor has created a scenario where they continue to enjoy the dividends and further upside of the stock up to $255.00. At the same time, they have a put contract that guarantees them a sale price of $230.00 if the stock was to begin to weaken. This gives the investor 6 months to see how the stock behaves. In addition, the investor delays having to make the decision to sell therefore defers the capital gains obligations. Considering the increasing question marks associated with the railway stocks, this is a great alternative for the investor that also allows them to sleep well at night knowing that if the bull market in railway stocks gets derailed, their profits and exit price have already been secured.