Time to get on board?

Transportation stocks are starting to recover – just the time to buy in, many would say. Is it also a sign that the wider economy is on the turn? Rodrigo Amaral investigates

Clandestine passengers in those old Western films always knew that the best time to get on board was when the train was still going slow. Once the engine started to move at full throttle, the whole exercise acquired a suicidal taste. Quite a few experienced equity investors have a similar view. The time to get into the market is right after it touches bottom, and share prices are about to gain steam. That could be the case with transportation stocks, a sector that has suffered severely in the past five years, and could see a reversal of fortunes in the near future.

Or maybe it could not. It can be argued that the fate of companies that depend on the transport of passengers or goods is closely correlated with the performance of the broader economy. So if you believe that the woes of Europe, the US and Japan are a long way from being over, trains, ships and airplanes are unlikely to be your thing. In fact, there is a school of thought according to which the performance of transportation stocks provides a reliable predictor of how equity markets as a whole will fare in the near future. If that is really the case, the best is to fasten your seat belt and brace yourself for more periods of turbulence.

In the past five years, the Dow Jones Transportation Average, an index made out of transportation stocks traded in the US, have gone through a considerably bumpy road. From a peak of more than 5,400 points that it reached in the happy days of April 2008, the index fell to less than 2,150 in March 2009. The false start of the first half of 2011 took the index up to more than 5,500 points by July that year, only to see it drop to below 4,000 points a mere three months later. In 2012, the DJTA delivered a tad over 2 per cent by early November. Which was of course six times less than what the S&P 500 index of the US’s largest blue chips.

The trajectory of the DJTA so far this year could imply it is either time to get into the transportation sector without further delay, or to get out of equity markets entirely. This is because, depending on the school of thought that an investor subscribes to, such stocks should either follow the way the broader economy goes, or to predict the future performance of markets.

The latter includes proponents of the Dow Theory, one of which proposes that companies that take merchandise from one point to another will be the first to benefit from a recovery of confidence among producers of industrial goods. However economists have asserted that the sector not only is reactive, rather than predictive, to other economy trends, but it also has tended to move in either direction more dramatically than GDP.

The Dow Theory dates back to the early 20th Century and for many economists it reflects a kind of economy that has completely changed in past decades.

“I don’t think transportation stocks are leading indicators of where the economy is heading,” says Alastair Gunn, a UK equities fund manager at Jupiter. “But they are good proxies for what is happening in the economy.”

Some analysts say the sector is in fact very broad and offer opportunities for several kinds of plays. In a recent interview to the Wall Street Transcript, Jefferies & Co analyst Peter Nesvold noted that some activities, like the transport of goods by lorry companies, follow the economic cycle instantly, while others, such as rails, tend to react more slowly. According to him, even those who like to bet against the tide can find opportunities in the sector, as logistics stocks have a tendency to be countercyclical.

Even within a sub-sector of the transportation industry the variations can be considerable, requiring careful analysis from investors. Moving people, for instance, is an activity less subject to dramatic ups and downs than carrying goods.

“Freight traffic is more exposed to the economic cycle than passenger traffic,” says Thomas Bücher, manager of the DWS Global Infrastructure fund. “As the economy goes down, it is the freight traffic that suffers the biggest falls of volume.”

The German economist Werner Rothengatter has noted that the current crisis has made this fact more evident than ever before. While long distance passenger transport fell 5 per cent in the rich world in 2009, international freight transport dropped by twice as much, he wrote in a report.

Flagship airlines have struggled as tourists and business travelers have became more aware of their travel costs. However low-cost alternatives have thrived as people who in other times would not even consider making a trip without a free meal have been forced to eat their pride instead.

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Toll road operators meanwhile are finding new opportunities in markets where the government is opening up the sector to private companies. But they are struggling in countries like Spain, where a wealth of redundant state-owned roads has combined with the economic crisis to push paying drivers out of their paid alternatives, even though they offer shorter and more comfortable routes.

For some companies, the way to mitigate the effects of a changing environment has been to diversify their activities. Experienced travellers, for example, are not surprised when they enter airports that look more like shopping malls than transportation hubs.

“In the Paris or Frankfurt airports, one of the ways they make money is to convince tourists to buy luxury goods in their shops,” Bücher says. “The retail component, especially luxury goods, is very important for the profitability of airports.”

One of the sectors of the economy more heavily hit by the economic troubles of the past five years has been the shipping industry. The International Transport Forum at the Organisation for Economic Cooperation and Development, OECD, a club of rich countries, has noted that ships transport about 80 per cent of the cargo that moves around the world. That means that world trade is highly dependent on shipping companies, but the other way around is also true. In the 2000s, this dependency amounted to record profits as companies were able to dictate prices to exporters and importers. Conversely, when global trade collapsed circa 2009, the industry sunk like the Titanic.

The depths reached by the shipping sector are illustrated by the evolution of the Baltic Dry Index, which measures the price charged by shipping companies to transport commodities around the world. In May 2008, at the height of irrational exuberance, the index climbed to almost 11,800 points, reflecting scorching hot global trade. In the five subsequent years, global trade has undergone many downs with a few ups scattered around, and the index duly reflected by this reality. In early November, it stood at a miserable 1,000 points. And that was already a significant improvement over February 2012, when the Baltic Dry Index sunk to to less than 650 points.

Shipping companies have suffered mightily with the crisis. To a considerable extent, as other sectors that boomed in the 2000s, they are paying the price of past follies. While global trade volumes rose, many appeared to believe there was no risk of a reversal of fortunes. Orders for new ships were made like there was no tomorrow. Worse than that, as it takes some three or four years for them to be delivered, ships that were badly missed during the boom are hitting the sea today, when demand for their services has reduced sharply. The outcome has been an excess of capacity that would have likely weighed on the sector even if the crisis had been less dramatic.

According to the United Nations Conference for Trade and Development the global merchant fleet could carry 822m tons of merchandise by the turn of the century. In 2012, the number has reached more than 1.5bn tons.

In the good, not too old days, shipping firms were the darlings of capital markets and were very much capable to raise capital in order to expand their fleets. “Lots of shipping companies listed in London in the heady days of 2006 and 2007”, Gunn says.

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After 2008, however, rates of global trade growth stayed well below the sanguine projections that justified the huge investments made.

“They have had a dreadful performance on the back of global trade being very poor,” Gunn adds. “And there is also too much capacity in the market today.”

It does not help either that a number of global trends are playing against them. For one, the impressive performance of the early 2000s was built on a foundation of cheap oil, which looks hardly a reality in the near future. The green economy, which is pushing companies to produce smaller and lighter items, reducing the volumes of goods being transported across the oceans, has also affected the industry, according to the ITF.

The falling out of grace has been such that several companies have gone out of business, including the oldest of the lot, the UK’s Stephenson Clarke, which went into liquidation in August claiming the current market is one “of the worst experienced for many years.” This is quite an alarming statement if one keeps in mind that the firm had been around since 1730 and, in its own words, have weathered many economic downturns in its almost three centuries of operations.

Stephenson Clarke stated that the firm does not believe the market will take a turn for the better in the next year or so. Others however consider that the shipping market has touched bottom and can only move upwards in the near future. In fact, any hint that the global economy is showing signs of leaving the intensive care unit can lift the value of companies in the sector.

As the economy goes down, it is the freight traffic that suffers the biggest falls of volume

According to Bloomberg, the rise of imports of containerised goods into the US, reported by a research firm in late October, was enough to give a boost to the shares of Maersk, a Danish shipping company which is one of the biggest dogs in the market. Shipping stocks have in fact gone through a bit of a revival for some months, but analysts have warned that many uncertainties still surround the sector. Not the least lingering doubts about China, the economy that is the main driver of global trade and, consequently, is set to have a major influence on the future of maritime transport.

Another fact to be considered is that the sluggish performance of trade is not a uniform, global phenomenon, but one that is much concentrated in the rich world. In fact, in some parts of the planet, seaborne traffic of goods has recovered to levels that are even higher than before the crisis, while in others they remain well below such peaks.

The usual suspects apply here. Exchanges of goods to and from Europe has been the worst performers, while intra-emerging market trade has done very well. It is a sign of the times that eight out of the 10 busiest ports in the world are found in the Asia Pacific area, while another is in Dubai (Rotterdam is the only Western port to make the cut, according to the OECD). So here is where the transportation story shows some real promise, becoming an opportunity to gain exposure to emerging markets.

“Transportation stocks are almost exclusively an emerging market play today,” Gunn says. “The real growth for trade today is coming from economies like China and India.”

The OECD has in fact noticed that, while volumes of foreign trade have receded or stagnated where the rich world is concerned, they have reached much higher levels than before the crisis among emerging markets. Investors have therefore been looking for ways to take advantage of this trend.

“Ports that have an exposure to intra-emerging market trade have a better chance to achieve growth of volumes today than those that depend on traffic to or from Europe,” Bücher points to as an example.

Thus the case for transportation stocks becomes similar to the one a number of fund managers have made for some time when they argue that infrastructure projects in emerging markets provide some of the best opportunities in the investment universe. Countries like Indonesia, the Philippines and Brazil have been less affected by the global slowdown than their richer peers. Growing trade links with China, India and other emerging market powerhouses mean that trade from and to such countries has not slacked as much either. Although emerging markets have fared less well this year than some expected, several economists believed that countries like China and Brazil have already turned a corner, and should post better growth rates soon.

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And there is the extra bonus that they actually lack much of the transport infrastructure that their economic dynamism demands. In the emerging world, hundreds of billions of dollars are being invested by governments in the upgrading of roads, railways, sea ports, airports and public transport systems. They are aimed at tackling problems that currently hamper the future prospects of whole countries, and therefore can hardly be postponed.

For example, it is estimated that Jakarta, the Indonesian capital loses more than $1.3bn a year because of traffic bottlenecks. Large investments are being destined to the mitigation of the problem, which is so severe that even an idea to move the capital to some other part of the country has been vented.

So transportation stocks exposed to developing markets could be a good option to investors that are looking for growth. But finding palatable alternatives might not be an easy task, especially if one is looking for them within the most interesting markets. “Regulatory risks are very critical for investments in the transport sector,” Bücher says.

If anyone needs a reminder of that, the recent experience of Louis Dreyfus Armateurs, a logistics group, in the commercial port of Calcutta, in India, will prove a timely provider. The French company invested heavily in a joint venture to explore two bulk terminals in the Haldia port, as part of a strategy heavy on emerging markets. But it has withdrawn from the business in early November claiming it was the victim of criminal activities and political interests.

Stephen Parr, a global emerging markets fund manager at Aberdeen, says that corporate governance can be an issue in some countries. “There are opportunities in Russia, but we are wary about corporate governance aspects there,” he says.

But a careful combing of the market can reveal some stockpicking opportunities that look as good as any company in the developed world, with the advantage they offer real chances of achieving growth. “We like well-run companies that are well positioned in their industries, and also in a good position to capitalise in the growth opportunities in their markets,” he says.

Parr highlights two examples in industries that often confound even experienced investors. One of them is in the Brazilian ports sector, which for a long time has baffled analysts for its labour rigidities, legal uncertainties and blatant inefficiencies. But Parr says that Wilson Sons, the third largest port operator in the country, has managed to build a smooth running, diversified business based on port management, but that also includes interests in logistics and offshore drilling support services, both of which have bright prospects in the South American country.

Another company that Parr likes is Asur, which manages nine airports in Mexico and has plans to expand its operations to other Latin American countries.

There has been a lot of discipline in the supply side. Carriers have been cautious in increasing their reach

“It is a conservatively run business with a strong balance sheet, with an exposure to a healthy mixture of domestic and international traffic,” he says. “It provides us with exposure to growth opportunities in Mexico and more broadly in Latin America.”

Other transportation firms selected by the Aberdeen manager include Brazil’s jet producer Embraer, Singapore Airlines and Hong Kong’s Pacific Basin Shipping, which thrives in international dry bulk shipping services.

Investors have also shown growing interest for construction firms that are engaged in the building of roads and railways in emerging markets, as well as engineering companies that provide equipments and maintenance services for underground systems and fast bullet trains that are mushrooming there. Interest is sometimes huge. A mere signal by the Chinese government that it would accelerate investments in the country’s underground railways has been enough to boost the price of railway equipment stocks in the country, even though analysts have warned that the announcement was actually nothing new.

However if one looks carefully, opportunities in the transport sector could be found even in developed markets. “US railway stocks have been among the most interesting investments of recent years,” Bücher notes The fact that megainvestor Warren Buffet was an earlier enthusiast of this particular group of companies, which he has described as key to the future of the US economy, has certainly helped. Gunn, for his part, says that something interesting for investors could come out of the granting of long term contracts to rail operators in the UK.

“They could generate earnings upgrades in the next few years,” he says.

Investors may also feel like taking a look at airline stocks, which have also been punished during the crisis. As companies cut travel budgets as they felt the effects of a sluggish economy, airlines lost a large amount revenue that was generated by the high paying, high frequency business passengers. 

People also traveled considerably less than before and many moved away from the traditional brands like British Airways or Lufthansa towards low-cost rivals such as EasyJet and RyanAir.
But airlines have been busy adapting themselves to the new economic environment, slowing down the expansion of their fleet and optimising routes. “There has been a lot of discipline in the air market supply side,” Gunn says. “Both low cost and flagship carriers have been cautious in increasing their reach.”

The market is also going through a consolidation process, with a number of important merger and acquisitions taking place in recent years. One example was the merger of British Airways and Iberia, which resulted in IAG, a company that is now trying to expand its presence in the low cost market too. Recently, household names like Air France-KLM and Lufthansa, which have gone through some rough patches in recent years, have been reporting solid results.

Furthermore, the Airports Council International, an association of airports, has reported that passenger traffic is back to growing at a solid pace, despite the European crisis. Between January and August this year, there were 4.5 per cent more passengers using the airports than in the same period of 2011. Growth has been particularly strong among international passengers, reaching 5.6 per cent. Unsurprisingly, that is to quite an extent thanks to those emerging market consumers that investors have been talking so much about. The three airports reporting the higher growth in the number of passengers can be found in Asia, with Jakarta registering a whopping 25.7 per cent increase. The numbers for air freight transport, however, continue to be disappointing, as they are more affected by the vagaries of world trade.

However all things considered, transportation companies still seem to be some way from impressing many investors, or at least those who are not focused on emerging markets. And while the economic uncertainty in Europe remains, their outlook does not look set for a dramatic turnaround.

“We see that very rarely have these companies paid dividends,” Gunn warns. “For income investors, it means that they are not meaningful right now.”