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by JT

Transportation has all the makings of an excellent business. It's a consolidated industry with a product that is necessary for day to day life on planet Earth. While it isn't very exciting as a business model, over the long term the transportation sector has rewarded investors with spectacular returns.

It's also extraordinarily cyclical. As anyone can imagine, the amount of freight to be moved from point A to point B varies greatly with the economy. After the Fedex earnings miss and news of a continued recession in Europe, we'll evaluate whether the transportation index and the various transportation ETFs still make sense for investors.

Sizing up the Transportation ETF

The most followed index for the space is the Dow Jones Transportation Index, which is also tracked by the largest transportation ETF by assets, the iShares Dow Jones Transportation Average Index Fund (NYSEARCA:IYT).

The fund offers investors a broad selection of transportation-related companies. The biggest holdings include:

  • Union Pacific Corp. (NYSE:UNP)
  • Kansas City Southern (NYSE:KSU)
  • FedEx Corporation (NYSE:FDX)
  • United Parcel Service (NYSE:UPS)
  • Norfolk Southern Corporation (NYSE:NSC)

There are no surprises in the above list. The ETF, which seeks to track the Dow Jones Transportation Average with representative sampling, has a naturally large position in railroads and parcel shippers, seeing as these industries are the most consolidated and thus have the largest companies by market cap.

The fund also includes smaller positions in Ryder Systems (NYSE:R) and J.B. Hunt Transport Services (NASDAQ:JBHT), both of which are engaged in shipping goods from point to point by truck.

Is the transportation sector worthy of your money?

The biggest weakness in the transportation sector ETF is undoubtedly its sizable airline positions. Over time, the airline industry as a whole produced zero profits for its investors and owners as competition eats what little profitability could be found in moving people from place to place.

The transportation ETF has more than 11% of the fund invested in Alaska Air Group, Southwest Airlines (NYSE:LUV), Delta Air Lines (NYSE:DAL), and JetBlue Airways Corporation (NASDAQ:JBLU). This is the most questionable part of the fund, exposure which investors may want to hedge out in order to boost total return.

Airlines are the only sector standing in the way of this otherwise exceptional fund. Seeing as it has a diversified mix of leaders in the transportation space, investors who hold for the long-term should enjoy the benefits that come from market leadership in a competitive space. UPS and FedEx, for example, enjoy better than economic returns on capital because of their wide moat. The same is also true of the railroad sector, as well as the trucking sector. The network effect insulates the largest players from competition and allows for above-average returns on capital.

There is only one major risk to the fund: rising interest rates. Remember, all of the companies in the transportation space rely on a very capital-intensive business model. When the cost of financing is high, these companies face a reality in which they have to invest in equipment that provides a return less than their own cost of capital. Low interest rates are easy money for capital intensive businesses. If you think high rates are just around the corner, then this fund is not for you. Low rates are a gravy train for the transportation industry.

Make transportation a core holding

A single earnings miss by FedEx does not taint the whole sector. By nature, this sector is very, very cyclical, but over the long haul, it has provided for returns in excess of the broad market. The total price returns of the Dow Jones Transportation Average totaled 173% over the last ten years compared to just 60% for the S&P 500 index. (For some other market-beating ETFs over long periods, consider the IPO ETF, the stock buyback ETF, or Sector Rotation).

(click to enlarge)

The .48% annual expense ratio for the iShares fund is more than reasonable for a diversified fund that provides exposure to 21 transportation industry leaders. Whether or not the index will be higher in one year than today is anyone's best guess, however, investors would be foolish to bet against the transportation sector's ability to generate high returns on capital while defending themselves from competition.

Transportation names aren't as cool as a dot com, but you can be sure many of the names in the index will be around in 20 or even 50 years, something you can't say about other industries.

Disclosure: No position in any tickers mentioned here.

Source: Why Transportation ETFs Should Be A Core Portfolio Holding