I highlight the importance of assessing the transportation industry's health and the potential of the iShares Transportation Average ETF for diversification and sector exposure.Economic indicators show a fragile recovery in the transportation sector, prompting caution due to already high valuations in transportation stocks.Personally, I opt for a gradual buying strategy for transportation stocks, particularly railroad stocks, and consider expanding investments during a significant sell-off.
Introduction
On October 24, 2022, I wrote my most recent article covering the iShares Transportation Average ETF (BATS:IYT). I am not necessarily covering the IYT ETF because I am looking to buy it (although it's a great transportation ETF) but because I have more than 15% freight and transportation exposure in my dividend growth portfolio. Assessing the health of the transportation industry is a key part of my research. After all, transportation companies connect buyers to sellers. Without them, the economy would come to a total halt.
The tricky thing is that we're not seeing clear signs of a recession and also no clear signs of a rebound. As we'll discuss in this article, sentiment (expectations) is somewhat in no-man's land. The same goes for transportation stocks. In general, they have held up quite well, with some outliers.
In this article, I'll elaborate on all of this and explain what I'm looking to buy.
So, let's get to it!
What's IYT?
Usually, I do not start these articles by discussing the characteristics of an ETF. However, in this case, it's important to understand what IYT is all about before we dive into economic numbers.
Incepted in 2003, IYT has become the largest transportation ETF with roughly $860 million in assets under management.
Managed by iShares (owned by BlackRock (BLK)), the ETF's objective is to “track the investment results of an index composed of U.S. equities in the transportation sector.”
There are three reasons to buy IYT, according to iShares. They are all somewhat related.
Getting exposure to airlines, railroads, and trucking companies without having to buy multiple transportation companies.
Targeting access to domestic transportation stocks.
Being able to express a sector view. This can be long or short.
With 44 total holdings, the ETF has invested 28% in air freight and logistics. Railroads account for 26%. Cargo ground transportation comes in third with 16% exposure.
iShares
Its largest holding is Union Pacific (UNP), my second-largest dividend growth investment. UNP has 17% total exposure. The United Parcel Service (UPS) comes in second with 16% exposure, followed by Uber Technologies (UBER) and CSX Corp. (CSX).
I really like the ETF's diversification and mix of both growth and value.
iShares
The only major drawdown I see is the ETF's 0.40% expense ratio. There is no reason to pay any company 0.40% per year for any service.
I prefer to build my own ETF. Although this comes with diversification risks, it comes with a 0% expense ratio.
My Own Strategy
I have done that by buying three railroads. I own Union Pacific, Norfolk Southern (NSC), and Canadian Pacific Kansas City (CP). While owning three railroads in a 21-stock portfolio is a lot, I feel very comfortable for a number of reasons.
Railroads are wide-moat businesses. Only a handful of Class I railroads dominate long-haul rail transportation in North America. They connect ports, major economic hubs, consumers, and everything you can think of in terms of transportation.
By buying UNP, NSC, and CP, I cover all bases. UNP dominates the West. NSC dominates the East, and CP connects all three North American nations, benefiting from re-shoring like no other.
Association of American Railroads
These investments come with consistent dividend growth and healthy balance sheets.
On top of that, I'm looking to expand my portfolio. At the right price, I'm looking to buy Old Dominion Freight Line (ODFL) or its smaller peer, XPO, Inc. (XPO).
I also own RTX Corp. (RTX), formerly known as Raytheon, which has 50% commercial exposure. This gives me significant aerospace exposure. This, too, is transportation.
However, in order to make the decision to invest more in transportation stocks, the bigger picture is key, which is why I'm writing this article.
What Does The Economy Tell Us?
The leading ISM Manufacturing Index has been below the neutral 50 line for 11 consecutive months. This hints at ongoing contraction in manufacturing (and related) industries.
In light of these developments, Bloomberg's Brooke Sutherland highlighted that all eyes are now on industrial stocks. This includes transportation stocks, as industrial demand is a huge driver of volumes. Also note that in the quote below, she mentions inventories, which drive transportation demand. I added emphasis to the quote.
The third-quarter industrial earnings season unofficially kicks off next week, with updates due from Delta Air Lines Inc. and Fastenal Co., the distributor of factory-floor products that’s typically a bellwether for the broader manufacturing group. Investor sentiment on the sector has soured markedly since the last round of earnings reports, with the S&P 500 Industrial Index down about 10% from the August peak amid concerns about the knock-on effects from rising interest rates and a drag from manufacturing weakness in Europe and China. An unusually large number of industrial companies fell short of Wall Street’s revenue expectations in the second quarter, and commentary about destocking — a phenomenon whereby customers prioritize shrinking excess existing inventories over placing new orders — became much more widespread. More of the same is likely on deck for third-quarter reports.
Having said that, with regard to the rebound in the ISM Index, historically, recovery follows such throughs. This time, however, the gradual decline could lead to a shallow recovery.
Analysts anticipate a 4% decline in orders for the industrial sector in the third quarter, indicating companies are shipping products faster than they can replenish their backlog.
There remains a risk of further deceleration in U.S. factory activity, as the ISM gauge can differ from the outlooks of individual companies.
Factors such as delivery times and inventories have been influenced by pandemic supply chain disruptions, causing unexpected challenges for businesses with shorter sales turnaround times.
While the rebound is shaky, we do see a rebound in other indicators. The Logistics' Managers Index is at 52.4. That's the highest number since early 2023.
This move is fueled by continued growth in the warehousing market, increased inventory costs, and some signs of green shoots emerging in the transportation industry. a slight tightening in the transportation market and continued growth in warehousing and inventory costs. Unlike last month, both Upstream and Downstream firms are seeing growth in the overall index, with respective readings of 51.2 and 53.4.
No products found.
We also see the same when looking at shipment indices of the New York and Philadelphia Federal Reserves. Shipments are a part of their monthly economic surveys, which tell us what we can expect in terms of transportation demand.
Although the recovery is extremely fragile, it does look like we can expect the Cass Freight Index to rebound in the next few months. After all, New York and Philadelphia Fed numbers are leading.
Leo Nelissen (Based on NY/Philly Fed data)
But wait, there's more evidence!
This is what FreightWaves wrote on October 5 in an article titled Rail intermodal volumes stabilize in September:
September was the highest month in 2023 for U.S. intermodal traffic, finding support in the peak season, according to the Association of American Railroads.
U.S. freight railroads originated 1 million containers and trailers in September, a 0.7% increase from September 2022. Year-over-year (y/y) comparisons so far this year have had intermodal volumes trailing year-ago levels.
“Intermodal had the best volume month of the year in September, showing, after three years, that ‘peak season’ still exists although much more reserved and occurring somewhat later than past peaks,” AAR Senior Vice President John T. Gray said in a Wednesday release.
That increase, albeit relatively modest, lent support to overall volumes in September. Overall volumes rose 1.5% to 1.93 carloads and intermodal units. Carloads, meanwhile, grew 2.3% y/y to 921,716.
FreightWaves
While it is way too early to make the case that the worst is behind us, it needs to be said that we're seeing a number of green shoots.
Now, the problem is that transportation stocks have priced in these green shoots. The chart below compares the average New York/Philly shipments data to the year-on-year performance of the IYT ETF. We see that IYT is much higher than usual in this environment.
Leo Nelissen (Based on NY/Philly Fed data)
The chart below shows the % IYT is trading below its all-time high compared to the ISM Index. Usually, the bottom is close to -25%. Now, IYT is just 18% below its all-time high.
TradingView (IYT % Below All-Time High)
Especially if economic growth shows another dip, we could see new selling in transportation stocks.
My personal opinion is that this will happen.
However, I'm not selling. I'm also not shorting.
I'm buying gradually on weakness. This year, I've aggressively added to railroad stocks, and I'll continue to do so. I'm buying now and will increase my investments if we get closer to a 25% sell-off.
I believe this strategy will suit me well, as I expect to hold my investments for decades.
At that point, I will also consider adding new transportation investments to my portfolio, as I need to see more weakness in some cyclical industries like trucking before buying.
Overall, I like the green shoots, but given the performance of transportation stocks, investors need to be careful.
Takeaway
In assessing the health of the transportation industry, it's evident that while there aren't clear signs of a recession or a robust rebound, the sector remains resilient.
Transportation stocks, especially the iShares Transportation Average ETF, have held up well despite uncertainties.
My strategy involves focusing on railroads for their wide-moat nature and consistent dividend growth. Despite the fragile recovery and the risk of a dip in economic growth, I'm not selling or shorting; instead, I'm gradually buying on weakness, particularly in the railroad sector.
The key is to remain cautious and observant of market dynamics, ready to capitalize on potential opportunities as they arise.
