Canadian Pacific Kansas City sees big opportunity from near-shoring. But why not invest in Mexico then?

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Canadian Pacific Kansas City Ltd. expects that its newly expanded North American rail network will position it well in the years ahead as U.S. companies, once enamoured with Asia, move production closer to their home bases and tap into Mexico’s low-cost labour force.

It’s a trend known as near-shoring, which certainly bolsters the case for investing in the railway. But if the trend lives up to expectations, investors might want to consider skipping the middleman and investing in Mexico instead.

Calgary-based Canadian Pacific CP-T gained its new reach after closing a deal to acquire Kansas City Southern Railway Co. in April. The merger combined North America’s smallest of the big freight haulers and links CP’s existing domestic network to additional lines that extend through Kansas City, Houston and deep into Mexico.

The added heft means that CPKC can serve customers that are moving production facilities back to North America to improve their supply chains and get closer to markets in the United States and Canada. The railway touted these benefits during its investor-day presentations this week, pointing specifically to Mattel Inc., which expanded its toy factory in Monterrey, Mexico, in 2022.

While near-shoring isn’t new, it gained urgency after international shipments were disrupted during the COVID-19 pandemic, adding significantly to shipping costs and waiting times. As well, it is a reaction to rising trade tensions between the United States and China, and a general retreat from globalization.

“We believe CP’s timing of KCS acquisition couldn’t have been better,” Konark Gupta, an analyst at Bank of Nova Scotia, said in a note.

“Even Chinese manufacturers are pivoting to Mexico, given the quick access to North American consumers,” Mr. Gupta said.

Morgan Stanley agrees. The financial giant earlier this month noted that 40 per cent of Mexico’s gross domestic product is tied to export manufacturing.

It expects that near-shoring will boost the country’s manufacturing exports to the United States to US$609-billion over the next five years, up from US$455-billion today – a 34-per-cent increase – which will provide a boost to GDP over the coming years.

“A boost in GDP growth would be transformative for domestic stocks,” Fernando Sedano, Morgan Stanley’s Latin America Economist, said in a note.

In other words, if near-shoring is good news for CPKC, it’s great news for Mexico – a market that is accessible to Canadian investors through exchange-traded funds and American Depositary Receipts (ADRs), and where stocks trade at valuations that are a fraction of, well, CPKC.

The railway stock has more than doubled over the past five years, rewarding investors who followed Warren Buffett’s approach to rails when his company, Berkshire Hathaway Inc. BRK-A-N, bought Burlington Northern Santa Fe in 2009. That was seen then as a long-term bet on the U.S. economy, and one that is generally immune to global competitive pressures.

But the rails aren’t cheap. CPKC’s shares now trade at 26 times trailing earnings, a valuation that puts the stock well above the price-to-earnings ratio of 12.9 for the blue-chip S&P/TSX 60 Index.

However, the railway delivered a sobering near-term financial outlook this week, reflecting the downturn in shipping volumes. It expects profit growth, excluding unusual gains and losses, in the mid-single digits this year. That’s lower than the 11-per-cent growth that analysts, on average, had been expecting.

Based on recent performance, Mexican stocks aren’t bargains either: The iShares MSCI Mexico ETF EWW-A, which gives investors exposure to 44 stocks, has already rallied 28 per cent so far this year.

But the gains suggest that Mexican stocks may be catching on as a direct bet on near-shoring. They can outperform indirect plays based in Canada or the United States. CPKC’s share price, for example, has risen just 4-per-cent year-to-date.

Even better, Mexican stocks trade at attractive valuations. The average P/E ratio for holdings in the iShares fund is just 10.8 – and investors get a dividend yield of 3 per cent. For access to individual companies, stocks like América Móvil, Fomento Económico Mexicano and Cemex trade in New York as ADRs, which are equity securities that allow investors to bypass foreign exchanges.

For sure, Mexico is an emerging market whose economy can deliver far more thrills and chills than a highly regulated North American railway. But if near-shoring gains momentum and Mexico becomes a clear winner from the trend, it looks like a strong bet.