Is It Time To Jump Aboard The Railroads?

Once a view takes hold among analysts and traders regarding a particular sector or industry it can be remarkably resilient.

Usually the view starts based on logic and reality, but once it becomes conventional wisdom cracks can begin to appear in both areas. Objectivity disappears when every piece of news or change in conditions is viewed only from the perspective of how it could be bad for the stocks, and that often leads to contradictions that border on the ridiculous.

The case against North American railroad stocks is an example. Obviously there are several factors that have caused the value of those companies to plummet.

First and foremost among them was the falling price of oil. By the middle of last year when WTI was up above $100/barrel railroad stocks were all the rage. The oil fields that were being developed by fracking in the U.S. were poorly served by pipelines and rail offered the best alternative. That led to an explosion of profit and what, with 20/20 hindsight, looks like a bubble in stocks in the railroad industry.

Once oil prices began to fall, though, that bubble burst with a resounding pop. All of a sudden, in addition to the threat posed by lower WTI, every analyst in the world started to focus on the potential negatives for railroads that had always been present but had, up to that point, been ignored. The interest rate hike that we know is coming will be bad for a capital intensive business like railroads, the U.S. economy started to look a little more sluggish than some expected, coal shipments were down, etc. etc.

The irony here is that the arguments that were used to dismiss those concerns a year ago are just as relevant now, in fact probably more so today than they were then. When the rate hike does come, the Fed has made it clear that it will be small and, more importantly, incremental. We will not see the rising rate environments of the past where every FOMC meeting heralded another 25, 50 or 100 basis point hike. Instead we can expect small raises in short term rates with significant pauses between them. That should give industries such as railroads and utilities ample opportunity to adjust.

In addition, the slowdown that was predicted has kind of happened, but it has not been particularly significant. The U.S. economy is still growing, and if this week's 3.7 percent GDP print is to be believed, any slowdown from Q4 2014 and Q1 2015 has been reversed. Coal is still in decline, but not every coal fired power plant will be shut down immediately so there will be a bottom to that decline, or at least a slowing down of the drop, and logic suggests that we are close to that point after years of the downturn.

So, with those negatives out of the way the continued decline in railroad stocks has to be down to the sustained drop in oil prices, right? Well, from a logical basis that argument doesn't make sense either. The reason railroads were hit in the first place was obvious…lower prices were expected to result in lower production and therefore massively reduced transportation of oil. That made sense, but the declines have continued precisely because production has not declined in any meaningful way, certainly not by as much as was feared.

The bears can't have it both ways. If significant production declines have not come as result of price declines so far, then they are unlikely to come at all. The market price for the crude is not directly related to revenues from transporting it, so, while there will be some pricing pressure on railroads it doesn't look like being enough to justify a 30-40 percent decline in market cap.

In short, the sector looks oversold at these levels. The obvious place to invest if you agree is in the big boys, so some kind of combination of Canadian National (CNI), CSX (CSX) and Union Pacific (UNP) makes sense to me. Whether you choose to go that route, select a single stock or go for even more diversification is a matter of personal preference, but increasing exposure to the industry makes sense at these levels.