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Buy List – October 2023: Canadian National Railway

My buy list for October 2023 has a new entry: Canadian National Railway (CNR.TO /CNI). I just love buying Canadian National Railway when the market expects a recession!

Railways are incredibly stable because there aren’t any other assets that can replace them in North America. Yet each time transportation volumes go down, the market tends to sell them off. It happened last in 2016, and we highlighted CNR.TO / CNI back then as well. Here we go for another round!

Canadian National Railway logoCanadian National Railway has been known as “best-in-class” for operating ratios for many years. CNR continuously worked on improving its margins and was among the first to do so. Today, peers have caught up and all railways are managed the same way.

CNR’s transportation activities are well diversified across seven different industries. Its exclusive access to the Prince Rupert port is advantageous for intermodal transportation. CNR enjoys a very strong economic moat as railways are virtually impossible to replicate.

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CNR.TO Business Model

A transportation and logistics company, Canadian National Railway’s services include rail, intermodal, trucking, and supply chain services. CNR rail services offer equipment, customs brokerage services, transloading and distribution, private car storage, and more.

Cute toy train set with wooden rails, trees, a station, signage and conductorCNR’s intermodal container services help shippers expand their door-to-door market reach with about 23 strategically placed intermodal terminals, with services including temperature-controlled cargo, port partnerships, logistics park, moving grain in containers, custom brokerage, transloading and distribution, and others.

CNR’s trucking services include door-to-door service, import and export dray, interline services, and specialized services. Its supply chain services offer comprehensive services across a range of industries and product types. CNR transports more than 300 million tons of natural resources, manufactured products, and finished goods throughout North America every year.

Investment Thesis       

Canadian National Railway owns unmatched quality railroad assets. With its strong economic moat, we can rely on increasing cash flows each year. There isn’t a more efficient way to transport commodities than by train.

The good thing about CNR is that investors can always wait for a down cycle to buy. Since we see railroads as attractive investments, we usually spot the opportune moment. Considering Q2 2023 results, it seems such a moment is here.

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CNR.TO Last Quarter and Recent Activities

With its Q2 results Canadian National Railway sent a strong signal that the economy is slowing down with revenue down 7% and EPS down 8% for the quarter. Revenue decreased mostly because of lower volumes of intermodal, crude oil, U.S. grain exports, and forest products. Volumes shrunk as demand for freight services to move consumer goods lowered and Canadian wildfires caused customer outages.

Rounding up the reasons for the decline were lower ancillary services including container storage, and lower fuel surcharge revenues as fuel prices decreased. CNR updated its full-year outlook, now expects flat to slightly negative year-over-year growth in adjusted EPS.

Potential Risks for CNR.TO

Railroad maintenance is capital intensive and could adversely affect CNR in the future. It’s a difficult balance to obtain an efficient operating ratio and well-maintained railroads. To maintain its network, CNR must make substantial reinvestments continually. However, CNR continues to boast one of the best operating ratios in the industry.

From time to time, CNR’s growth can be negatively affected by its dependence on the Canadian resource markets. When demand for oil, forest, or grain products is low, demand for CNR’s services obviously slows down accordingly. For example, the pandemic caused a slowdown in weekly rail traffic of about 10% over the summer of 2020. As you can see in the graph below, even that didn’t derail (couldn’t resist) CNR’s revenue much or for very long.

Line graph showing CNR's revenue growth over 10 years- steady growth except in 2020-2021 due to the pandemic.

When the oil price is low, trucking steers some business away from railroads. CNR is a captive of its best assets since you can’t move railroads!

Get acquainted with other great Canadian stocks, read Canadian Forever Stock Selection.

CNR Dividend Growth Perspective

Canadian National Railway has successfully increased its dividend yearly since 1996. The management team ensures they use a good portion of CNR’s cash flow to maintain and improve railways, while rewarding shareholders with generous dividend payments. CNR exhibits an impressive dividend record with very low payout ratios. To learn more about payout ratios read this article.

Line graph of Canadian National Railway dividend amount for the last 10 years; yearly increases, with a generous increase early 2022 as business normalized after the peak of the pandemic.

While the business faces headwinds periodically, its dividend payment will not be affected. Shareholders can expect more high single-digit dividend increases. The railroad company kicked off 2023 with an impressive dividend increase of 8%. If you can grab CNR with a yield of approximately 2%, you’re making a good deal!

Learn strategies for generating income for life. Download our guide now.

Final Thoughts on Canadian National Railway

Despite CNR’s capital-intensive requirements and reliance on the Canadian resource markets, we believe Canadian National Railway will come sailing through the current economic downturn and maintain its dividend increases.

With CNR’s unmatched-quality railroad assets almost impossible to replicate, and its management taking on the challenges of the current environment, we could see more growth emerging from all this. Also, CNR will benefit from the cancellation of the Keystone XL pipeline which will drive demand for oil transport via railroads. With a current yield above 2%, CNR is definitely worth a look.

Retirement Tax Optimization Basics

Tax optimization is an important aspect of retirement planning. Beyond saving, investing, and accumulating wealth, examine how you can reduce the amount of tax you pay when retired.

Canadian currency, bills and coins, on white backgroundThis article doesn’t go deep into tax issues because each situation is different, with different applicable rules and tax rates. However, there are situations we all have in common upon retirement. After your retirement strategy is outlined, i.e., your global asset allocation, risk tolerance, types of investments, etc., you’re in a good position for some tax tweaking. Don’t do it the other way around.

Why do I believe one should perform tax optimization only after you have set your investing strategy? Because while it’s good to trim your tax burden, you should not do it at the expense of the bigger picture. In other words, I don’t think it’s all that bad to pay withholding taxes on dividends received if it enables you to have a more diversified and better performing portfolio.

See also Create your own Paycheck in Retirement

However, when it’s time to retire, the order and timing of withdrawals can greatly affect your budget. You can’t control your portfolio performance, but you can control a part of the taxes you’ll pay, or save, at retirement. Therefore, crunching numbers with a tax expert is likely to make a big difference in your lifestyle.

Canadians, learn about government retirement benefits.  Download our CPP and OAS guide.

My take on tax optimization

I’m not a tax expert, but after doing hundreds of financial plans for my clients as a financial planner back in my banking days, here are my conclusions.

First, know that there are no magic tricks for optimizing taxes. Any strategies viewed as “too aggressive” by regulators will be rejected and you’ll get a slap on the wrist

Two women talking while sitting at office table in front of brick wallThe best tax advice I can give you is quite simple: spend a few thousand dollars with a fee-based financial planner and an accountant. They’ll do the hard work and offer you a customized plan to optimize your taxes. Make your appointment, develop a plan, and avoid potentially costly mistakes.

To know more ahead of consulting an expert, or if you want to skip consulting and do it yourself, learn about the simple 3 Ds of tax optimization: Deduct – Defer – Divide.

Deduct: maximize deductions, reduce your taxable income

Anything you can use to reduce your taxable income automatically lowers your taxes, especially if you live in a country with increasing marginal tax rates like Canada. Examples of deductions you can use to reduce your income at any age include contributions to your retirement plans, interest paid on loans used to procure non-registered investments, and healthcare expenses.

Defer: postpone paying taxes as long as you can

Here’s a tip for my Canadian readers (I’m pretty sure it applies to Americans too, but you should verify this first). It sounds counter-intuitive, but in most cases, deferring the moment when you withdraw money from your tax-sheltered account (such as your RRSP account) is worth it. Here’s why.

The longer you wait to withdraw money from a tax-sheltered account or to trigger capital gains, the longer your money is growing tax-free. At retirement, it’s usually preferable to let your tax-sheltered account grow while withdrawing money from regular investment accounts, if possible. Remember that all investment income coming from a taxable account, whether it is withdrawn or reinvested, is income in your tax declaration.

Plant growing in clear glass pot filled with coinsSome retirees are tempted to withdraw money from tax-sheltered accounts earlier to pay less tax, as they assume their marginal tax rate to be lower at 60 years of age than at 85, when they anticipate they’ll have to withdraw more money. However, when you withdraw money, you pay the taxes immediately. The money paid to the government can’t compound going forward. Withdrawing at a younger age means you miss out on years of growth on tax paid.

For example, if you need $7,000, you could sell shares in a taxable account and pay a small amount in capital gains. Perhaps you’ll have to sell for $7,500 to receive $7,000 net of taxes. You could also sell for $10,000 in your RRSP to receive $7,000 after taxes. That extra $2,500 paid in taxes won’t compound tax free inside your RRSP for the next 20 years. At a 7% investment return, each $2,500 turns into $9,674 in 20 years from now. That’s almost 4 times the original amount!

Divide: divide your income with a spouse

Two cedar waxwing birds on a branch, with one giving a berry to the other

You can split assets or income sources with your spouse to keep each of your incomes in a lower marginal tax rate brackets. You’ll pay a lot less in tax if you split $100K of income 50-50 than keeping it solely under your name.

 

Tax optimization take away

Unfortunately, there are no secret ways to make taxes disappear, other than those usually referred to as fraud or evasion. If you’re Canadian and dislike the OAS claw back, look at it this way: being asked to payback some of the OAS benefits you received is a good problem to have; it means you likely have plenty of money to enjoy your retirement.

Canadians, learn about government retirement benefits.  Download our CPP and OAS guide.

An accountant can do a great job at drawing up a plan to optimize your taxes; the best way to approach tax optimization is to run multiple scenarios and see the impact of each choice. Don’t forget to always focus on your investment strategy first. Saving money in taxes is great, but making higher total returns is even better! Adding risk or reducing total return for the sake of taxes isn’t a good idea.