For much of this year, the Dow Jones Transportation Average has been underperforming the broader Dow Jones Industrial Average. But in May, a wide divergence began to form between the two indexes, and there is currently an almost 900 basis point spread between the two.
That disparity is largely due to bad news out of the transportation sector-Federal Express Corp FDX issued weaker-than-expected earnings guidance in mid-September, and railroads and trucking companies have been struggling with lower cargo volumes. Followers of Dow Theory believe this could portend a coming correction.
If the omens are correct, that means there should soon be some terrific bargains ahead in equities. Given the overwhelmingly negative sentiment already at work among transports, the sector would offer especially compelling values following a selloff.
But even if a stock market correction doesn't come, with everything from railroads and airlines to freight companies and equipment manufacturers generally trading at discounts to their historical valuations, transportation stocks are a solid buy at these levels.
With the US economy showing some signs of life, particularly the recent rise in home prices in some of the hardest hit areas and improving demand for new homes, transports should strengthen over the coming months.
Norfolk Southern NSC has sold off sharply since providing weaker than expected earnings guidance in mid-September, forecasting third-quarter earnings per share [EPS] of approximately $1.18 to $1.25.
The railroad laid the blame squarely on king coal. Rock-bottom prices in natural gas have caused electric utilities to switch over from coal, and railroad earnings have suffered from the corresponding decline in coal demand.
Union Pacific Corp UNP also hasn't been immune to weak coal demand, recently reporting that railcar loads were off by 17 percent as a result of weak coal shipments. Weakness in the coal market was hardly unexpected given the glut of natural gas and the unseasonably warm winter, but it has weighed heavily on the railroads. Norfolk Southern is off by more than 11 percent so far this year, and Union Pacific has sold off from its 52-week high of about $130 down to below $120. In turn, that has prompted a wave of analyst downgrades of both individual railroads and the sector as a whole.
But for savvy investors, the recent weakness in the sector is an opportunity to pick up railroads on the cheap as they continue to adapt to their market environment.
In the case of Union Pacific, it's combating weakness in coal shipments by focusing more on petroleum and natural gas, a trend that's increasingly occurring across the industry. According to data from the Association of American Railroads, while coal shipments have declined by 9.6 percent so far this year, petroleum products have risen by 40 percent.
In the second quarter, Union Pacific saw petroleum carloads rise by 12 percent, as it hauled equipment into the Bakken Shale region and petroleum and gas products out. In all, its shale business is expected to grow to about 400,000 carloads this year.
By contrast, Norfolk Southern's strategy has been to focus more on intermodal traffic and efficiency improvements.
One of its most interesting projects was a recent upgrade to its Heartland Corridor, a 379-mile stretch of track running from seaports in Virginia to Chicago, to accommodate double-stacked intermodal freight trains. Hauling two intermodal containers on a single car not only lowers costs for shippers, it also adds nearly a third to the revenues generated by each train.
It also invested heavily in network upgrades to accommodate more daily freight and passenger trains in America's heartland. That will enable the railroad to move more cargo out of Canada and to accommodate more energy-related cargo from the nation's shale plays.
Thanks to its heavy network investment, Norfolk Southern has one of the greatest velocities in the business and is consistently rated one of the most efficient railroads in the nation.
Both Union Pacific and Norfolk Southern will benefit from growing petroleum shipments in the coming years. Continued improvement in both the housing and automotive industries will also help to increase freight volumes, while higher fuel costs will push more long-haul freight off the roads and onto railroads.
A secondary play on the rail industry is Trinity Industries TRN, a major manufacturer of railcars, such as freight and tanker cars as well as railcar axles and coupling devices. It is also one of the largest leasers of railcars and provides management and administrative services, such as regulatory compliance and fleet optimization.
The company also manufactures inland barges, which are commonly seen in the Great Lakes region, and structural towers for wind turbines, as well as highway guardrails, concrete and construction aggregates.
Revenues at Trinity rose by 40 percent last year and are on track to grow by another 28 percent this year. Most of that growth is being driven by Trinity's railcar operations, which are currently working through a backlog of about $3.2 billion, a large portion of which is for tanker cars to haul petroleum products. The largely one-off revenues generated through its leasing and management services saw 16 percent growth in operating profits last quarter.
Trinity will continue to benefit from the structural shift the railroads are experiencing in the types of cargo they haul, a trend which should drive new railcar order growth over the next few years.
Shifting gears a bit, Swift Transportation SWFT, the largest truckload carrier in North America, is also a worthwhile transport play. Analysts have soured on trucking companies, Swift in particular, because of the slow domestic economy and tight federal regulation imposed on the industry. While those are definite headwinds, Swift is attractive because its truckload mileage should increase by about 1 percent this year and 3 percent in 2013 due to greater industry consolidation.
Both reduced competition and Swift's "Plus One" program, which aims to add one new load to each of its 16,000 trucks each week, have helped drive huge efficiency gains and widening margins over the past year. The trucker is also working to expand its intermodal fleet with a goal of adding between 1,000 to 1,500 containers to its fleet each year through 2015. What's more, it's establishing partnerships with railroad companies for loading and unloading.
Given the capital-intensive nature of its business, Swift does carry substantial long-term debt of about $1.5 billion. That's caused many investors to shy away from the company and has seriously compressed its valuation over the past year.
However, with only $8.3 million of its debt maturing over the next four years, it's well positioned to pay that down out of its growing free cash flow, which broke $100 million last year.
Disclosure: I am long NSC.