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.
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
S&P STARS: Since Jan. 1, 1987, Standard & Poor's Equity Research Services has ranked a universe of common stocks based on a given stock's potential for future performance. Under proprietary STARS (STock Appreciation Ranking System), S&P equity analysts rank stocks according to their individual forecast of a stock's future capital appreciation potential versus the expected performance of a relevant benchmark, e.g., a regional index (S&P Asia 50 Index, S&P Europe 350 Index or S&P 500 Index), based on a 12-month time horizon. STARS was designed to meet the needs of investors looking to put their investment decisions in perspective.
S&P Earnings & Dividend Rank (also known as S&P Quality Rank): Growth and stability of earnings and dividends are deemed key elements in establishing S&P's earnings and dividend rankings for common stocks, which are designed to capsulize the nature of this record in a single symbol. It should be noted, however, that the process also takes into consideration certain adjustments and modifications deemed desirable in establishing such rankings. The final score for each stock is measured against a scoring matrix determined by analysis of the scores of a large and representative sample of stocks. The range of scores in the array of this sample has been aligned with the following ladder of rankings:
S&P Issuer Credit Rating: A Standard & Poor's Issuer Credit Rating is a current opinion of an obligor's overall financial capacity (its creditworthiness) to pay its financial obligations. This opinion focuses on the obligor's capacity and willingness to meet its financial commitments as they come due. It does not apply to any specific financial obligation, as it does not take into account the nature of and provisions of the obligation, its standing in bankruptcy or liquidation, statutory preferences, or the legality and enforceability of the obligation. In addition, it does not take into account the creditworthiness of the guarantors, insurers, or other forms of credit enhancement on the obligation. The Issuer Credit Rating is not a recommendation to purchase, sell, or hold a financial obligation issued by an obligor, as it does not comment on market price or suitability for a particular investor. Issuer Credit Ratings are based on current information furnished by obligors or obtained by Standard & Poor's from other sources it considers reliable. Standard & Poor's does not perform an audit in connection with any Issuer Credit Rating and may, on occasion, rely on unaudited financial information. Issuer Credit Ratings may be changed, suspended, or withdrawn as a result of changes in, or unavailability of, such information, or based on other circumstances.
S&P Core Earnings: Standard & Poor's Core Earnings is a uniform methodology for calculating operating earnings, and focuses on a company's after-tax earnings generated from its principal businesses. Included in the Standard & Poor's definition are employee stock option grant expenses, pension costs, restructuring charges from ongoing operations, write-downs of depreciable or amortizable operating assets, purchased research and development, M&A related expenses and unrealized gains/losses from hedging activities. Excluded from the definition are pension gains, impairment of goodwill charges, gains or losses from asset sales, reversal of prior-year charges and provision from litigation or insurance settlements.
S&P 12 Month Target Price: The S&P equity analyst's projection of the market price a given security will command 12 months hence, based on a combination of intrinsic, relative, and private market valuation metrics.
Standard & Poor's Equity Research Services: Standard & Poor's Equity Research Services U.S. includes Standard & Poor's Investment Advisory Services LLC; Standard & Poor's Equity Research Services Europe includes Standard & Poor's LLC- London and Standard & Poor's AB (Sweden); Standard & Poor's Equity Research Services Asia includes Standard & Poor's LLC's offices in Hong Kong, Singapore and Tokyo.
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.
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.
As of Sept. 30, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 28.1% of issuers with buy recommendations, 51.1% with hold recommendations and 20.8% with sell recommendations.
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.
5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.
4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.
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.
1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.
Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index and in Asia the S&P Asia 50 Index.
For All Regions:
All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.
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Readers should note that opinions derived from technical analysis might differ from those of Standard & Poor's fundamental recommendations.
Stovall is chief Investment strategist for Standard & Poor's