Rail Stock Roundup: 2 To Buy, 1 To Avoid

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If you are bullish on the macroeconomy, it makes sense to buy railroads. Not only do they track the economy, they are expected to grow at a faster rate than stocks in broader indices. Surprisingly, this preferable growth curve has not been factored into the stock prices, since railroads trade at a discount in terms of multiples. While the S&P 500 trades at 18.9x past earnings, railroads, on average, trade at just 13x past earnings. Below, I review three stocks that in the space that you should consider buying.

Why You Should Buy CSX (NYSE: CSX)

This leading railroad has underperformed peers with a return of -9.2% over the six months versus a positive return of 11% from Union Pacific. Will this underperformance continue? It is expected to grow EPS by a rate of 14.9% over the next five years, which is in-line with the railroad industry average. Price-to-book and price-to-earnings ratios are roughly in-line with the average as well at 2.2x and 11.1x, respectively. Return on invested capital? Also in-line at 12.4%. These are great fundamentals and support a bullish perspective on the rail industry. But while 13 of 24 reporting analysts recommend buying the stock, a large minority, 11 are on the fence with a "hold".

I side with the bullish half, and here's why. Free trade legislation is on the rise, which provides a major secular transition in favor of rail. We can see this with the rising trade between the United States and Mexico. Union Pacific, for example, saw cross-border carloads rise 6% leading up to the end of 3Q versus its 1% overall volume growth. And while the poor coal market caused CSX's earnings to fall in the third quarter, the downside is more than factored into the stock price. This is evidenced by how the PE multiple trades well below the 14.1x historical 5-year average.

I also believe that the market is looking too much at the coal market and too little at intermodal and industrial where robust growth has been relentless. Domestic volume gained 6% in the most recent quarter and set a record--this was reflective of not only market trends but corporate innovation, such as the UMAX interline container program. Growth opportunities are also emerging in chemicals and the automotive market. 

Kansas City Southern (NYSE: KSU) Vs. Norfolk Southern (NYSE: NSC)

KSU and Norfolk are two other major railroads. The former trades at a respective 23.6x and 20x past and forward earnings versus 11.1x and 10.8x for Norfolk. KSU gets the premium due to how it is at a steeper part of its growth curve--it is forecasted for a nearly 500 bps faster growth rate over the next five years at 17.6%. Assuming expectations are met, 2016 EPS will come out to $6.65. At a multiple of 15x, this translates to a future stock value of nearly $100. That provides a 5.4% average annual return over the next 5 years--not nearly enough to justify an active stock investment. To put this into perspective, if Norfolk ends up at a multiple of 15x at any point within these 5 years, it beat KSU's average annual return by 160 bps with no growth.

There are several other reasons why you should be bullish on Norfolk Southern. It generates a strong 12.6% return on invested capital and is at a discount compared to peers. While the industry average price-to-book multiple stands at 2.2x, Norfolk trades at just 1.9x book value. Around 3.8% of the company is held by core value investors, and this is solid when you consider that Apple--one of the stocks institutions are most bullish on--has just 1.6% of its investors classified as "core value". Poor third quarter performance has knocked down shares 19.8% from the 52-week high, and this has created a major opportunity for long-term minded investors to pursue a "buy-and-hold" strategy.


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