After languishing in $60 range for most of 2011, CP Rail’s stock exploded higher in December on news that activist hedge fund, Pershing Square, acquired a material position in the stock. Pershing’s goal is to shake-up the management at CP, by installing Hunter Harrison as CEO. Hunter is a legend in the railroad business. As CEO of CN Rail, he was able to transform the company into the most efficient and profitable railroad in North America. With CP’s stock trading at $72, the market believes that Hunter has enough lightning left in his bottle for another go around.

Last week we sold all of our client’s holdings in CP Rail above $72.50. Even if Pershing is successful and Hunter becomes CEO, it will be many years before any benefits are realized at CP. In the meantime, CP’s stock is overvalued and provides us with no margin of safety. We expect CP to earn about $4.20 in 2012, this means at $72.50, CP’s stock is trading at 17 times this year’s earnings. The most inefficient and least profitable railroad is now trading at a premium to all of its peers. This is a red flag to us. For example, CN Rail is trading at 14.5 times this year’s earnings and U.S competitor, CSX Rail, looks like a bargain at 12.5 times this year’s earnings. The deal closer is a comparison of CP’s valuation to the overall market. The S&P 500 is trading at approximately 12.5 times this year’s earnings. It’s hard to justify buying CP’s stock when it is valued at a 35% premium to the overall market. Fair value for CP, in our opinion, is probably closer to 15 times this year’s earnings, which means its stock is worth $63. If you can’t justify buying more, than you should sell.

Mean reversion is a value investor’s best friend. A value investor looks to buy a quality company selling below its intrinsic value and then sells that company when it is valued at a premium. The value investor has to believe that value will surface over time, companies trading at a discount to its peers and to the market, will revert to fair value. The corollary also must be true, companies valued at premium to its peers and the overall market, must come back to earth. A little bit of mean reversion and a lot of patience will reward the value investor.

Disclosure: Clients of Baskin Financial own shares in CSX Rail.