Are some companies just naturally more profitable than others?
There are 6 large railways in North America (7 if you count Kansas City Southern as well). Canadian Pacific (CP) is the smallest by market cap and most inefficient among them (see my 2008 post on CP’s ranking among the Class 1 Railroads). Last year, hedge fund Pershing Square Capital Management bought enough shares to become CP’s largest shareholder and demanded immediate changes to make CP run more efficiently and more profitable.
There is one problem. Here is CP’s railway network. Here is rival’s CN’s rail network (CN is the most efficient railway in North America and often cited as a model for CP to emulate). See a problem? CP’s railway network tunnels through the Rocky Mountains. CN’s more or less avoids it. The British Columbia to Alberta part of the rail network is important because of the amount of goods being shipped to and from the ports of Vancouver and Prince Rupert to the Asian market.
Perhaps growing frustrated by Pershing Square’s criticism that CP is not efficient, CP admitted last week that there are “structural makeup[s]” of the two railways that make CN an easier railway to run from an efficiency perspective. In other words, CP was basically saying “hedge fund, please meet reality.”
Can CP become more efficient? If you looked at its financial statements and industry metric for efficiency, known as operating efficiency, the answer would be yes. This is the type of information that a hedge fund or average investor would have access to. But, financial statements do not disclose issues like a structural disadvantage of a company compared to its competitor, company morale or corporate culture (judging from comments from friends who have worked at RIM when things were going well, never has the saying “culture eats strategy every single day of the week” been more adapt).
The passive school of investing often talks quite rightfully about the statistical inability to beat leading indexes over time. However, the other issue with active management is that “soft” investing factors which often do not necessarily show up in a balance sheet affect stock prices.
Here is the hard truth. 99% of us, including hedge fund mangers, cannot accurately measure the impact on these types of soft factors on stock performance. I wish Pershing Square well. CP is certainly an industry laggard and needs an external push to make it more efficient.
However, I am perplexed that a hedge fund can believe that management should literally move mountains in order to make it more efficient. Then again, hedge fund managers believe themselves to be gods so re-shaping the earth shouldn’t be so hard right?