Railroads: Less Room to Chug?


By Sam Stovall A recent addition to the High Momentum List is the S&P 1500 Railroads subindustry index. Year-to-date through Dec. 23, this index gained 31.2%, vs. a 5.5% advance for the S&P 1500. That leads us to the big question: Is any upside potential left?

Andrew West, who follows the group for Standard & Poor's Equity Research, says his fundamental outlook for the railroad industry is neutral. He thinks shipping volumes and prices will continue to benefit from a broad economic expansion continuing through 2006, and he expects profits to benefit during this upcycle.

RISING TRAFFIC. Nevertheless, he sees neutral valuation indications and is concerned that, if the economy's growth rate slows, investors may rotate out of these stocks, into other groups. In addition, the industry has generally underperformed after past interest rate hikes, although past performance does not necessarily serve as a guide to future results.

West sees rail revenues rising about 12% in 2005, following a 9% advance in 2004. Traffic in ton miles (weight times distance) increased about 4.9% in the U.S. in 2004, and rose 2.5% year-to-date through Nov. 19, according to estimates by the Association of American Railroads. Total carloadings rose 2.9% and were up 0.9% year-to-date through Nov. 19. Intermodal volume set a record in 2004, rising 10.4%, to 11 million trailers or containers, and it rose 6.2% year-to-date through Nov. 19.

He believes freight rates will continue to rise in the coming year, on firm demand, tight capacity, and rising fuel surcharges. He sees aggregate operating earnings for major U.S. railroads rising more than 20% in 2005, with slower growth in 2006. However, his expectations for railroad shares are limited by the maturing economic cycle, perceived fair valuations, high fuel and employee costs, and difficulties in managing railroad system fluidity amid higher volumes.

TIME TO CUT WASTE. West's longer-term outlook for railroads is favorable, though he expects moderating revenue and profit growth in 2006. He sees the industry's core traffic base (coal, grain, chemicals, and intermodal) increasing in line with the economy.

In addition, he sees opportunities to expand margins and operating efficiency by improving service levels, eliminating what he views as wasteful labor practices, and using improving information systems to boost future operating efficiency and aid capital budgeting decisions. As a result of 2001 guidelines by the Surface Transportation Board, he sees future rail mergers among the four largest U.S. railroads as unlikely."

The industry's relative-strength price chart is shown below. As a reminder, the jagged blue line represents the subindustry index's rolling 52-week price performance as compared with the 52-week performance for the S&P 1500. Any point above 100 indicates market outperformance over the prior year, while points below 100 indicate market underperformance. The red line shows a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the subindustry index's 15-year mean relative strength.

So there you have it. In S&P's view, while the subindustry's price momentum may look strong, our fundamental outlook is neutral based on underlying valuations and concern over possible sector rotation.

Industry Momentum List Update

For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of Dec. 23, 2005.

Industry

Construction & Engineering

Diversified Metals & Mining

Fertilizers & Agricultural Chemicals

Health Care Services

Managed Health Care

Oil & Gas Drilling

Oil & Gas Equipment & Services

Oil & Gas Exploration & Production

Oil & Gas Refining & Marketing

Railroads

Specialized Finance

Water Utilities

Glossary

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A+

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High

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In Reorganization

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Average

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Below Average

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Required Disclosures

In the U.S.

As of Sept. 30, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 28.7% of issuers with buy recommendations, 60.3% with hold recommendations and 11.0% with sell recommendations.

In Europe

As of Sept. 30, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 34.8% of issuers with buy recommendations, 44.8% with hold recommendations and 20.4% with sell recommendations.

In Asia

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Globally

As of Sept. 30, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 29.3% of issuers with buy recommendations, 57.7% with hold recommendations and 13.0% with sell recommendations.

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3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.

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Stovall is chief Investment strategist for Standard & Poor's


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