GATX: Interesting, But Too Risky

It's been just over two months since I wrote my cautionary note on GATX Corp. (NYSE:GATX), and in that time, the shares have returned about 17.4% against a gain of 9.4% for the S&P 500. The company will announce earnings next week, so I thought I'd check back on the company to see if it makes sense for me to buy back in. I want to review a few of the points made by the CEO during the most recent Wells Fargo Industrials Conference, as these were very interesting to me. I'm also going to review the valuation to see if the shares are more attractively priced today.

I know that my writing can be a bit much for some readers to take, and for that reason, I put a "thesis statement" near the beginning. This allows you, the reader, to get into the article, get the "gist" of it, and then get out again before you get too much Doyle mojo all over yourself. You're welcome. Making your reading experience as pleasant as possible is the first thought I have when I wake up, and it's the last thought I have before my head hits the pillow. I care, hence the "thesis statement." The risk of this investment is still too great in my estimation. The company has some great growth opportunities, and I think they're renewing leases at above-average rates at the moment, but the stock is near multi-year valuations, and the dividend yield is significantly below the risk-free rate. That's troublesome for me. As an investor, I'm not looking for "returns", I'm looking for "risk-adjusted" returns, and in a world where I can get nearly 4% for a 10-year Note, and 5.3% for 1-year, I see little value in hitching myself to this wagon, at a time when North American freight is having such a hard time.

3 Highlights of the Latest Wells Fargo Industrials Conference

A little over a month ago, the CEO of GATX gave a brief talk at the Wells Fargo 2023 Industrials Conference, and he made some interesting points that I think are worth reviewing. They offer an interesting insight into the GATX business, and what we should expect for the remainder of this year. They also offer an interesting insight into what's going on at railcar manufacturers, and what we might expect from those businesses. The Wells Fargo analyst made the point that railcar loadings are horrible and that we're in "a freight recession", and given that, why would leasing be such a good business? The CEO responded thusly during the conference:

Well, I would say the cycle is different this time around than ones in the past because the lease rates on existing cars are being much more driven by the supply side and so it's been more of, as you would guess, a supply-led recovery and lease rates versus demand. Now, we would love for demand to kick in but right now our customers are much more in the mindset of holding onto the equipment they have, they're not necessarily looking to add to their fleets given the issues you've raised. So, they've struck a pretty cautionary tone on that front. But they want to hold onto what they have. So, that gives us, and other lessors, the opportunity to move lease rates up because we know they don't want to let go of the equipment and their alternative is to build new. I'm sure the railcar manufacturers would entertain that call, be happy to get that call, but car prices are high. Steel costs, input costs, raw material, labor, everything else. So, their alternative is pretty pricy, and we think about establishing lease rates off of that new car alternative. So, we've been able to move rates up pretty materially and certainly in the first quarter we did, again, and we think the full year, if things stay the way they are, it feels like 2023 for the full year should be in a pretty healthy spot.

All that said, the things you mentioned are correct. Customer are frustrated with the service levels from the railroads, and I think if the service levels improve, they would move more product from truck to rail but right now they're unwilling to make that commitment.

In my view, the CEO made two interesting points here.

1. Demand for railcars is fairly muted at the moment, but, because the alternative for customers is to buy new, GATX is in a position to raise lease rates. This is one example of how the company benefits from generally rising prices. When the current lease rate is above the long-term, inflation-adjusted trend for lease rates, GATX attempts to lock in longer terms to achieve higher cash flow.

2. Another way in which the company is an interesting hedge against inflation is the fact that it owns hard assets around the world. Quoting the CEO again:

Inflation has historically been GATXs friend. For anybody who's a hard asset owner, and we own a lot of assets around the world, some level of inflation is a good thing because, again, we're pricing leases today off of the new car alternative, whether it's in Europe or whether it's in North America, that new car alternative, that price has gone up. Now, rampant inflation you don't want because it causes a whole host of other issues, but some level of inflation is generally a good thing, and we own a lot of steel. We own a lot of hard assets around the globe, and they have increased in value.

Finally, the company has been involved in India for a little over 10 years now, and they've built up the business from nothing to about 6,000 cars in the fleet today. That's a tiny fraction of the Indian freight network, obviously, but I think it represents a significant growth potential in South Asia.

Given the combination of inflation protection, the fact that the company is renewing leases at above trend rates, and the significant growth potential overseas, I'm certainly willing to reconsider this investment. I'd be happy to buy back in at the right price.

The Stock

If you're one of my regulars for some reason, you know that I consider the stock and the business to be different things. I've written my reasoning so often that I worry about boring my regular readers. Although I may "worry" about it, I don't care enough to not do it, so here goes. The business generates money by leasing assets, mostly freight rail cars. The stock, on the other hand, is a slip of virtual paper that gets traded around in the public markets, and the up and down price movements often reflect more about the mood of the capricious crowd than it does anything to do with the company. The price moves may be related to the changing appetite for "stocks" as an asset class, or changing interest rate policies, etc. Additionally, when the crowd does react to what's going on at the firm, it often overreacts, and these overreactions are the source of potential profit, in my view.

Many people dismiss my idea that we need to review the stock separately, because they believe that "we don't buy stocks, we buy businesses." That lines up nicely with one of the messages we've all intoned for years, so it doesn't cause that much dissonance, but consider the following: an investor who bought this "business" less than two weeks ago, on July 5 is basically flat on their investment. A person who bought the next day is up 4%. Not much changed at the business to warrant a 4% variance in returns over one day. If you want to invest well, it's really, really important to only buy the stock at the right price.

A word for "right price" is "cheap", which is why I really like buying cheap shares. I measure cheapness in a few ways, ranging from the simple to the more complex. On the simple side, I like to look at the ratio of market price to some measure of economic value like earnings, free cash flow, and the like. I want to see a stock trading at a discount to both the overall market and its own history. In my previous missive on GATX, I lamented the fact that the PE ratio was sitting around 25.9 times, the PS ratio was 3.15 times, and the dividend yield was 1.85%, about 300 basis points lower than the risk-free rate. Fast-forward to the present, and the valuation is about 14% more expensive per the following:

I'd also point out that the price to sales ratio is very near a multi-year high. Additionally, the dividend is currently about 212 basis points lower than the 10-Year Note.

In addition to looking at ratios, I want to look at what the crowd currently expects from the future for a given company. I do this because I want to buy when the crowd's expectations are too dour and sell when the crowd becomes too rosy. I want to try to quantify these expectations as much as possible, and to do that, I turn to the works of Stephen Penman and/or Mauboussin and Rappaport. The former wrote a great book called "Accounting for Value" and the latter pair recently updated their classic "Expectations Investing." All of these writers consider the stock price itself to be a great source of information, and the former in particular helps investors with some of the arithmetic necessary to work out what the market is currently "thinking" about the future of a given business. This involves a bit of high school algebra, where the "g" (growth) variable is isolated in a standard finance formula. Applying this approach to GATX at the moment suggests the market is assuming that earnings will grow at a rate of about 9.5% for the foreseeable future. That is an extraordinarily optimistic forecast, in my view.

I think the market is reasonably optimistic here, and in some ways, this optimism makes sense, given some of the positive trends we see at GATX. The problem is that, in my view, this great news is already "priced in", so I think the upside is limited from here, and the downside is potentially large. We're not looking for "returns." We're looking for "risk-adjusted" returns, and on that basis, I think the 3.7% an investor can receive risk-free over the next decade is the superior option, superb dividend history or no superb dividend history.