Riding the rails: Road map to recovery

NEW YORK (CNNMoney.com) -- Truckers, railroads and other transportation companies are seeing a pickup in demand for the first time in four years, a strong vote for the economic recovery. But for stock investors, timing an entry point into the sector is tricky.

"We're ending a four-year recession in the freight market, thanks to a repaired credit market and a little help from the consumer," said Art Hatfield, senior transportation analyst at Morgan Keegan. "I think it's a leading indicator for the economic recovery."

Freight demand tends to falter six to 12 months ahead of a broader recession and pick up six to 12 months before a bigger recovery, he said. Freight demand turned down in mid-2006, over a year ahead of the recession, which officially began in December 2007.

Hatfield said the pickup in demand reflects the improvement in consumer sentiment and also the recent slowdown in the pace of job losses.

But with the Dow Jones transportation (DJT) average and the iShares Transportation (IYT) index at levels not seen in 18 months, many of the stocks have already seen a big run-up. The two indexes are up 16% year to date, versus a rise of just under 6% for the Dow Jones industrial average and 8% for the broader S&P 500 index.

"The stocks have done extremely well," Hatfield said. "Pricing and earnings for the sector should start to pick up later in the year and that's probably when the stocks will make another move up."

Other analysts argue that while select stocks have gotten pricey, the sector as a whole is on a roll.

"The transports have started to break out relative to the broader market, and the path of least resistance is higher, with momentum supporting that strength," said Katie Stockton, chief market technician at MKM Partners.

She said the sector is primed to run up as much as 20% in the next three to six months, driven by truckers, shippers and global delivery firms FedEx (FDX, Fortune 500) and UPS (UPS, Fortune 500), rather than the railroads. Airlines are classified as transportation stocks too, but are being driven by different factors including mergers and the fallout from the volcanic ash that grounded planes to and from Europe earlier this month.

Hatfield is most bullish on FedEx and UPS. He said that, unlike the airlines, they can benefit from short-term events such as the volcanic ash scare, which has created a backlog for them. Both companies reported better-than-expected first-quarter earnings and gave encouraging forecasts.

Railroad stocks are primed for longer-term strength relative to the rest of the stock market, Stockton said, but they've already rallied a lot in anticipation of a pickup in demand.

The group is likely to see see earnings growth of 20% in the next two to three years and stock price growth of about 10% to 15%, said John Mims, a transportation analyst at BB&T Capital Markets. Companies he covers include Norfolk Southern (NSC, Fortune 500) and Union Pacific (UNP, Fortune 500).

Truckers such as Con-Way (CNW, Fortune 500) and shippers Overseas Shipholding Group (OSG) and Diana Shipping (DSX) have more room to run in the near term, said Stockton.

"The truckers are in an earlier stage of the advance and the shippers have been oversold and are primed for a recovery," she said.

Best first quarter in six years: Demand - measured by freight volume - has picked up since the middle of the first quarter, marking a shift from inventory rebuilding to the start of actual growth as consumers start to feel better.

That shift is also beginning to be reflected in the broader economy.

Friday's GDP report showed that the economy grew at a 3.2% annualized rate after growing at a 5.6% rate in the fourth quarter of last year. While the pace of growth was slower, the report also showed that the economy is transitioning from a period of inventory rebuilding to one of broader expansion. In addition, consumer spending grew at a 3.6% annualized rate.

"What we've seen is a sustained improvement, not just a restocking," said Todd Fowler, transportation analyst at KeyBanc Capital Markets. "We're finally seeing the start of a true organic building of inventories."

Fowler said the rise in broader retail sales activity year-to-date and in year-over-year store sales is encouraging.

A pickup in demand tends to predate higher prices and earnings by at least six months, the analysts said. Higher prices and earnings are needed to give the stocks a bigger push, meaning the next wave up in stocks is likely a fourth-quarter phenomenon.

Earnings growth has been mostly in line, with companies benefiting from weak comparisons to a year ago, like the rest of the S&P 500. But executives have been fairly bullish about the future, BB&T's Mims. "They're saying they're either in the early stages of recovery or a more definite stage of recovery, particularly the truckers."

Pricing is crucial: Fowler says the sector is entering a period of expansion that should drive up pricing for the first time since 2006, prior to the housing market collapse. Morgan Keegan's Hatfield says he's hearing anecdotally that some distributors are having trouble finding enough trucks, which he says is a leading indicator for improved pricing.

Other analysts are wary of anticipating better pricing amid the modest pace of the broad economic recovery.

"Business is improving and that makes the pickup in demand look sustainable, but pricing isn't going to do much this year," said John L. Barnes, managing director at RBC Capital Markets.

If pricing doesn't pick up much, neither will earnings, or stock prices. Barnes' top pick among the companies he covers is Ryder (R, Fortune 500), which reported a big jump in first-quarter earnings last week.

Other headwinds besides the threat of pricing flattening out include rising fuel costs, which have typically had a mixed impact on the industry. Investors also need to be careful as they approach a sector so economically sensitive, the analysts said. Transportation companies cut jobs on par with other sectors, and have not made many strides toward rehiring. The pace of U.S. job losses has slowed, but a period of sustained hiring is still months away.

"The biggest risk to the group right now is the same risk for everyone - some sort of pullback or double dip in the economy," said Fowler.

"Transportation companies have a big exposure to the consumer," he said. "While we know the consumer is feeling better, the environment is nothing like it was six or seven years ago."