Investors are driving railroad stocks to the best start to a year since 2008, looking past downgrades by Wall Street analysts, in a bet that Warren Buffett is right about the carriers’ long-term prospects.
A 23 percent surge for the Standard & Poor’s 500 Railroads Index in 2013 is outpacing the S&P 500’s 14 percent jump. The gains are being extended even with the proportion of buy ratings on Union Pacific Corp. (UNP), the largest U.S. railroad, and Kansas City Southern, the fastest growing, at the lowest since 2010.
Crude-oil cargo, a homebuilding rebound and the fastest auto-sales pace in six years are buoying earnings, and options market trading data analyzed by Bloomberg show investors expect the rally to continue. The rail index’s return has almost doubled the S&P 500’s advance since Buffett’s Berkshire Hathaway Inc. (BRK/A) agreed to buy Burlington Northern Santa Fe Corp. in 2009.
“If you believe the U.S. economy is on a path, no matter how slow, to a recovery, then the railroads will benefit from it and probably more than most,” Andrew Davis, an analyst at Baltimore-based T. Rowe Price Group Inc., said in a telephone interview. The firm oversees $617.4 billion, including stock in the four biggest publicly traded U.S. rail carriers. “Some of these stocks, the valuations are quite high relative to their history, but they’re not so inflated that it’s crazy.”
The rally pushed the Standard & Poor’s 500 Railroads Index to a 7.2 percent premium to the S&P 500 Index on a price-earnings basis today, compared with a 34 percent discount in May 2009, Bloomberg data show.
Those valuations are starting to temper analyst assessments. Cherilyn Radbourne, an analyst at TD Securities in Toronto, cut her rating on Union Pacific to hold from buy on April 29, citing “the stock’s recent strength and valuation,” according to a client note.
The Omaha, Nebraska-based company, whose $154.50 price is 18.2 times its earnings per share over the past 12 months, has a buy recommendation from 63 percent of analysts, down from 86 percent a year ago, Bloomberg data show.
“The valuation makes Union Pacific not as attractive as its eastern counterparts,” Logan Purk, a St. Louis-based analyst at Edward Jones & Co. who has a hold rating on the stock, said in a telephone interview. “There’s more value in the eastern franchises because there’s more opportunity for growth.”
East Coast railroads traded at a discount to the S&P 500’s 15.8 price-earnings multiple and their ratings from analysts have begun to improve.
Norfolk Southern Corp. (NSC), based in Norfolk, Virginia, traded yesterday at 14.3 times earnings, and the share of analysts awarding it a buy rating has climbed to 50 percent from a four-year low of 39 percent in January.
CSX Corp. (CSX), with a price-earnings ratio of 13.7, has seen the percentage climb to 58 from 53 in February, the Jacksonville, Florida-based company’s lowest since May 2009.
All four companies gained today, led by Kansas City Southern’s 2.3 percent advance to $108.36 at the market close in New York. CSX rose 2.1 percent to $24.73 and Norfolk Southern increased 1.6 percent to $76.81. Union Pacific gained 1.9 percent.
Even with the stocks hovering at about the highest prices on record, the cost of options hedging against losses in the securities has declined, a sign of confidence that the rally will continue.
Options to sell, or puts, with an exercise price 10 percent below Union Pacific’s stock price cost 6.16 points more than calls betting on a 10 percent gain yesterday, according to three-month data compiled by Bloomberg. That’s near a two-year low for the price relationship known as skew and 6 percent below its one-year average.
“There’s less demand for downside protection and falling risk perceptions among stocks like these,” Fred Ruffy, senior options strategist at WhatsTrading.com in Chicago, said yesterday via phone. “The options trading makes sense, since there’s more optimism around the sector as railroads have rallied.”
Skew for CSX was 5.56 points, 9.1 percent below its average for the past year, while the measure for Norfolk Southern was 6.27 points, the data show. For Kansas City Southern (KSU), puts cost 5 points more than calls, 12 percent below the 12-month mean.
The railroad, which traded at 32 times earnings, is rated a buy by just 36 percent of analysts after its share price increased more than eightfold since April 2009. That propelled the Kansas City, Missouri-based railroad into the S&P 500 last month.
The rail carriers’ advances are beginning to show signs of leveling off, with the S&P 500 Railroads Index posting its biggest one-day loss in more than seven weeks yesterday. The gauge has fallen 4.1 percent from an all-time high on May 20.
Buffett, who described the purchase of Burlington Northern as an “all-in wager” on the U.S. economy, didn’t immediately respond to a request for comment sent to an assistant.
“Fundamentally, we’re probably closer to the end than the beginning of what everyone’s been calling a rail-stock renaissance,” T. Rowe Price’s Davis said. “These stocks have been iterating an excellent performance year after year for going on 10 years now.”
That performance is due in part to efficiency improvements that helped to boost earnings.
Operating ratios, an industry performance gauge that compares expenses to revenue, fell to 71.5 percent at the largest publicly traded North American railroads in the first quarter, according to data compiled by Bloomberg. That was the lowest for the period in more than nine years.
Union Pacific may increase petroleum carloads by as much as 40 percent this year, Chief Executive Officer Jack Koraleski said in an interview at Bloomberg’s headquarters last month.
That follows a threefold increase last year that helped push annual profit to a record $3.94 billion. Industrywide, shipments of chemicals, which include crude oil, have climbed 13 percent so far this year, according to Association of American Railroads data.
“This is a legitimate trend that’s going to extend the current cycle,” Eric Marshall, head of research at Dallas-based Hodges Capital Management Inc., said in a telephone interview. “We’ve continued to add to Union Pacific. It’s an area we still have a good deal of exposure to and we like the business long-term.”
The rise is helping to blunt the impact of a 4.3 percent decline in coal carloads for North American railroads in the same period, though coal accounts for a bigger share of freight traffic.
U.S. auto sales at a 15.3 million annual rate after adjusting for seasonal trends last month are helping push car shipments by rail up 1 percent this year, AAR data show. Building permits jumped to a 1.02 million yearly pace in April, according to the U.S. Commerce Department, helping forest-product volumes grow 1.2 percent.
“The floor isn’t going to fall out from underneath the big-picture story for the railroads,” Lee Klaskow, a senior logistics analyst with Bloomberg Industries, said by telephone from Skillman, New Jersey. “It’s really incredible with the rails how, over the past 10 years, whenever one part of their business goes into a decline, something else comes to the fore as a growth area.”
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