2 Railroad Operators To Buy This September

| About: Union Pacific (UNP)

The S&P 500 has posted an average loss of 0.52% in the month of September, according to the Stock Trader's Almanac. While that might sound like bad news, it's good news for investors looking to buy.

Those who take advantage of the markets typical September swoon are usually nicely rewarded by the end of November.

I've already outlined some of my favorites in large cap consumer and technology here and here. But, you may not want to ignore railroads either. Both Union Pacific (NYSE:UNP) and Kansas City Southern (NYSE:KSU) tend to trade higher into fall as utilities increase winter coal stockpiles.

September selling leads to gains into fall.

The market never moves in a straight line and always seems to go faster and further than we think. If you've watched the markets for a while, you've noticed there are certain times of the year when markets, sectors, industries and stocks do better - or worse. And, despite the attention getting headlines for September and October sell-offs, you shouldn't ignore the chance to buy into those downturns for future gains.

Since 2003, the S&P 500 has finished November higher than it starts September 9 times, generating an average and median return of 1.95% and 4.07%, respectively. So, while September and October weakness provides plenty of media fodder, investors are better served looking beyond the next six weeks.

Source: Seasonal Investor Database

These 2 railroads should be on your buy list

There are two large-cap rail operators you should be watching this month. Union Pacific and Kansas City Southern have posted strong returns through November, suggesting September may be a good time to buy.

1. Cost control and pricing power suggests this operator will head higher

King coal has been the biggest headwind holding railroad operators back. Rails have been enjoying substantial growth transporting construction and import/export related goods. But coal accounts for 40% of total volume and the industry has struggled to overcome the drop in demand for it.

Natural gas prices are low thanks to rapid production growth in formations like the Marcellus Shale. But while coal volume isn't likely to hit heyday levels anytime soon, it may be stabilizing. At Union Pacific coal volume was essentially flat in Q2 from a year ago, accounting for 19% of sales.

If stabilization continues, strength in other categories - like automotive and petroleum - can have a bigger impact on Union Pacific's financials; particularly given operators have adjusted costs to reflect much lower levels of coal shipments. In Q2, Union Pacific was able to leverage pricing power against a 4% lift in volume to generate 12% sales growth from automotive. And strength in oil and related products drove volume and sales up 10% and 12% in chemicals last year, respectively.

Union Pacific's adjusting to shifting markets helped it grow earnings per share 13% in Q2 from a year ago. That's much faster than the 5% growth in revenue. The earnings leverage came thanks to a 1.3% improvement in the company's efficiency ratio, which hit a record 65.7% in the quarter. And, those sales and earnings are especially good when you consider total rail volume fell 1% in the quarter, weighed down by agriculture dropping 10% from a year ago.

With coal and grains on the sidelines, pricing and expenses are doing a lot of heavy lifting at Union Pacific. Despite flat coal volume, Union Pacific's coal sales were still up 12% year-over-year in Q2.

"We managed our network efficiently and continued to show the agility of our strong franchise. When combined with solid core pricing gains, we more than offset the slight shortfall in volumes to generate best ever quarterly earnings and operating ratio performance," said Jack Koraleski, Union Pacific chief executive officer, in the Q2 earnings release.

That success should continue into the seasonally attractive pre-winter shipping season. Over the past 10 years, Union shares only dropped in the recessionary hard hit 2008. Overall, shares have climbed an average and median 6.05% and 12.14% from September through November, respectively.

Source: Seasonal Investor Database

2. Mexican made Silverado's and Rams help this operator's profits climb

Automotive has proven a big winner for Kansas City Southern, which I discussed in 2011 here. The operator manages lines that reach down to fast growing Mexican automobile manufacturers and gets over 20% of its revenue from cross-border sales. Investments over the past few years to boost Mexico's auto production coupled with America's renewed appetite to buy helped Kansas City Southern's auto volume increase 7% from last year. That volume was leveraged against better pricing to produce auto sales growth of 20% last quarter from a year ago.

Revenue grew a bit faster than Union Pacific's last quarter, improving 6% thanks to 3% volume growth. Results would have been 5% better if not for the weakness in agriculture. Still, Kansas City Southern's tight fisted approach to spending has paid off as operating costs have grown just 16% over the past four years while sales have grown 54%. That helped last quarter's diluted earnings per share grow 9% to $0.96.

Even stronger than automotive was energy, where Kansas City Southern reported volume and sales growth of 12% and 26% last quarter, respectively. The energy strength reflected improving coal shipments, reinforcing industry stability. During the quarter, Kansas City Southern shipped 17% more utility coal than the brutally low volume shipped a year ago. This prompted Kansas City Southern to bump up its full year forecast for energy to double digit line haul revenue growth from high single digit prior predictions.

The company's success should continue this year too. The U.S. light vehicle daily sales rate increased 12.8% in August from last year, bringing year-to-date unit sales growth up 9.6%, according to Ward's Automotive. And, Kansas City Southern was able to improve its interest expense by refinancing $1.2 billion in debt last quarter. Its interest expense for this year is projected 20% below 2012, adding $0.15 per share to earnings, supporting forward earnings.

As for timing, shares of Kansas City Southern have historically rallied over the next three months, finishing higher in 9 of the past 10 years. Shares have generated an average and median 9.33% and 13.34% return through November.

Source: Seasonal Investor Database

The final take

The worst may behind rail operators coal shipments. If grains can similarly stabilize, both of these operators should benefit from volume as utilities build up winter coal stockpiles and farmers harvest this season's crops. Intermodal, construction, petroleum and automobile volume and pricing all remain tailwinds. Given these operators have culled expenses, positive seasonality suggests September is a good time to buy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.