Stock prices of companies in one of my favorite industries — railroads — were obliterated last year, so it's nice to see them back on the mend.
Shares of Norfolk Southern Corp., Union Pacific Corp. and CSX Corp. finally hit rock bottom early this year, with all of them down about 40 percent from previous highs. But since January, railroad companies have rebounded, which could be a harbinger of better economic times ahead.
That's because railroads, along with other transportation stocks like airlines and trucking, are a barometer of industrial economic activity. While it is true that two-thirds of U.S. economic activity comes from consumer spending, the other third involves industrial production.
Dow Theory Forecasts, a stock market newsletter, predicted: "A sustained pickup in industrial activity could help U.S. gross domestic product finally accelerate north of 2 percent."
Before this rally, the rails were caught in an unrelenting crossfire of negative economic news, and by January 2016 their stocks were priced as if the sector might disappear. Imagine that — a world devoid of that lonesome whistle blowin'.
The culprits were many. First, crude oil prices collapsed in 2014 from above $100 barrel to below $40 a barrel, which caused oil producers to cut back on rail shipments of crude oil and fracking sand. Coal shipments have also declined in recent years as power plants transitioned to cleaner natural gas.
For example, in 2012 about 7.6 million tons of coal were shipped by rail, accounting for 42 percent of total rail tons, according to the Bureau of Transportation Statistics. By 2015, that figure had dropped to 6.3 million tons, or 35 percent of the total.
Secondly, U.S. manufacturing also slowed last year, which had a negative impact on the rail industry. The Institute for Supply Management's Manufacturing Index, a common measure of manufacturing activity, fell throughout 2015 to below 50 by the end of the year. An ISM Index reading below 50 indicates the sector is contracting.
On top of all that, the strength of the U.S. dollar against overseas currencies made U.S. exports of chemicals, grains and steel more expensive and less competitive. This led to a decline in exports and ultimately in rail activity.
But over the last eight months, railroad stocks have been on fire. Norfolk Southern is up 44 percent, Union Pacific has gained 38 percent and CSX is up 35 percent.
These gains are the result of crude oil prices stabilizing and moving above $45 a barrel. The ISM Index also moved higher this year — above 50 — although it dipped slightly below that level in August. And the dollar has weakened a bit, making U.S. exports cheaper, a tailwind for manufacturers and rails.
The number of rail freight carloads remains well below previous years, but an uptick in carloads since April indicates stabilization in the sector. The number has increased from 1.04 million carloads in April to 1.1 million in July, the most recent data available.
"These stocks sold off too much last year," said Eric Marshall, head of research for Hodges Capital Management, a Dallas investment firm. "Freight volumes haven't increased significantly, but the rail stocks have moved up in anticipation of stability."
When a sector rallies as far and as fast as rails have, stock prices may outpace earnings, pushing valuations to excessive levels. But the estimated stock price-to-earnings ratios of Union Pacific remain a modest 16.7 and the p/e ratios for Norfolk Southern and CSX are even lower at about 15.
This is below the p/e of the S&P 500, which currently resides at 18. Marshall said investors who buy rail stocks at these levels should do well over the long term because earnings are expected to improve enough to support even higher prices.
For example, Union Pacific expects earnings per share of $5 this year, but that is expected to improve to $5.67 per share in 2017, a 13 percent improvement. The other railroads are also expecting improved earnings going forward, and investors in these companies can also pocket annual cash dividends above 2 percent.
An interesting sidelight to the railroad industry is that while it accounts for less than 1 percent of the market capitalization of the S&P 500 Index today, in the late 1890s railroads held center stage in the U.S. economy. They were the nation's most valuable companies.
In fact, the precursor to the Dow Jones Industrial Average, developed by Charles Dow in 1896, was comprised solely of the nation's 20 largest railroad companies.
While their prominence has certainly faded, they are, thankfully, not disappearing, and investors curious about where the economy is going should hop aboard.
