Freight transportation supply and demand have become more balanced as the U.S. economy begins to recover, allowing the trucking industry to take some sizable price increases over the past 18 months, but recent federal regulations may further tighten supply capacity offsetting this balance, says John G. Larkin, CFA, Managing Director at Stifel, Nicolaus & Co., Inc.
“Provided the economy continues to grow anemically, 1.5% to 2%, which has been the average over the last couple of years, that should allow carriers to continue to take price, especially if the Federal Motor Carrier Safety Administration, FMCSA, changes the hours of service rules effective at the end of this December, which has recently been announced,” he said.
Larkin likes Con-way Inc. (CNW), which is a mostly nonunion, western truckload carrier. CNW also has a nonunion truckload subsidiary that has exposure into and out of Mexico as well as a standalone asset-light logistics company called Menlo Logistics, which is one of the leading logistics companies in the industry, he said.
“We like Con-way because of the operating leverage inherent in the income statement and think that if pricing continues to move in a positive direction, that they are going to be able to grow earnings faster than some of the other companies in the industry,” Larkin said.
Railroads have been enjoying a strong secular push on core pricing, and these long-term benefits are expected to continue as U.S. GDP and industrial production experience modest growth, says Christian Wetherbee, Senior Analyst in the industrials group at Citi Investment Research & Analysis.
“[Industrials] are taking business off of the road and on to the rail because fuel prices are high and the rails are more fuel efficient, their service continues to get better, pricing is very solid, so everything is working well for them right now,” he said. “The fundamentals of the railroad industry are very, very solid, so we like that group.”
Wetherbee has a “buy” rating on Union Pacific Corporation (UNP), which he says is trading below its historical average. He says stocks in the railroad group are in the neighborhood of about 12.5 times earnings multiples.
“We’re trading still about a turn below their historical averages on earnings multiples next year, and so we feel like that’s probably one of the more interesting and attractive places to put capital these days,” Wetherbee said.
Rising operating costs, higher equipment prices, driver scarcity and increasing truck regulatory pressures are resulting in an upward bias to freight pricing broadly, which serves as a favorable backdrop to parcel pricing, says Benjamin J. Hartford, CFA, a Senior Analyst at Robert W. Baird & Co., Inc.
“We believe that even in a relatively weak demand environment, we should see domestic freight pricing continue to rise, which is a theme that we believe investors should focus on over the course of the next few years. Investors should watch and assess which models and modes of transportation will be able to benefit from the rising cost of capacity,” he said.
Hartford says given this positive freight rate bias, he favors United Parcel Service, Inc. (UPS), which he believes is uniquely positioned to realize better-than-expected parcel pricing this cycle. As far as the asset-based cyclical stocks are concerned, the constraints in truckload capacity provide for structurally better pricing trends during the upcoming cycle, Hartford said.
“They [UPS] have greater international growth opportunities that can support revenue growth over the course of this cycle. The barriers to entry in the parcel market are as high as they have ever been, which provides the opportunity for improved operating margins and capital returns this cycle,” he said.
Companies with dividends and global sales, where demand is expected to grow faster than in the U.S., offer investors a way to obtain ROE in a current slow-growth, low-yield environment, says Mark D. Petrie, CFA, a Vice President and Director of Research at Hokanson Associates.
“We also prefer companies with a sustainable competitive advantage, such as scale, pricing power or market position. We want companies that are taking market share, growing faster than the underlying trend they are participating in,” he said. “The good news is there’s an abundance of stocks with these characteristics available in the market today.”
Petrie says NICE Systems Ltd. (NICE), an Israel-based provider of software and hardware for digital security and surveillance, is a play into the global security trend. NICE is a leader in call center technology that monitors and reports on fraudulent financial transactions, and is positioned to serve the growing demand in the sector.
“A variety of trends including a rise in global terrorism, growing populations and economic difficulties in many areas of the world have resulted in increased demand for intelligent surveillance,” he said. “Global businesses, airports, rail networks and government facilities around the world are expanding their security and surveillance budgets and upgrading to more complex systems with improved storage and retrieval capability.”
Volatility in the markets, which may be more driven by macroeconomic fears than analysis, offers the opportunity to find new investment ideas by allowing investors to react to business fundamentals and buy attractive franchises at good prices, says Edward O’Connor, CFA, a Partner and Analyst/Portfolio Manager at Cooke & Bieler.
“We’ve seen these risk-on, risk-off trades. Sometimes you find great companies that maybe have some economic cyclicality, but investors are selling them in a flight to safety, and you can buy great companies at very attractive prices if you’re willing to live with a little volatility,” he said.
O’Connor gives State Street Corp. (STT), a large custody bank, as an example of taking advantage of macro trends. He says demographic and market trends for the long term are in their favor, so it’s a business that’s likely to continue to grow for some time.
“There have been some concerns about pricing in some ancillary services, and to some extent they get caught up in concerns over financial regulation and capital requirements and just a general aversion to anything labeled a bank, so it’s given us an opportunity to buy what we think is a great company at an extremely attractive valuation,” O’Connor said.
Pet product retail is expected to maintain consistent traffic during the currently slow economic growth environment, with pet food and other consumables resilient to trade-downs because of pet-owner attachment to their animal companions, says Daniel Hofkin, an Analyst at William Blair & Company, L.L.C.
“People tend to spoil and dote on their pets. They will sometimes sacrifice their own eating or spending, but especially among older families or empty nesters, pets are often considered children. And people like to treat their pets as such, not just in terms of continuing to buy them the food that they are used to, but also in terms of other products,” Hofkin said.
Hofkin says PetSmart, Inc. (PETM) is well positioned in the retail sector from a long-term standpoint as a specialty retailer, because pet food is roughly half of the company’s inventory, while the rest consists of other pet products, such as cat litter.
“We don’t currently have an ‘outperform’ rating on PetSmart, primarily because we are watching the impact high gas prices and input-cost inflation will have on the traffic, particularly in hard goods. But I would say that’s more of a temporary concern, and it doesn’t appear to have materially impacted PetSmart’s results so far,” Hofkin said.
The outlook for large-cap securities for next year appears stable as the U.S. economy continues to slowly recover and corporate earnings inch higher, says Frederick J. Ruopp Sr., CFA, Chairman and Chief Executive Officer at Chelsea Management Company.
“I told clients at the beginning of this year that I thought we would be able to do 6% to 8%, maybe 10%, and I think it’s going to be somewhere between the 6% to 8%. I don’t feel too differently for next year,” Ruopp said. “With additional growth and with the market not being wildly overpriced right now, we ought to be able to do 6% to 8% this coming year.”
Ruopp likes Johnson & Johnson (JNJ) because it is selling at 12 times earnings with a 3.5% dividend yield and shows several years of increasing its dividend. He says pharma is looking interesting for the first time in a long time and he is looking for companies with strong balance sheets and a solid record of rising earnings, dividends and good industry position.
“If everybody has some residual worries about the economic cycle in this country, pharmaceuticals pretty well exist outside of the economic cycle, because we have to have them. So those are interesting companies that have done well and continue to do well,” Ruopp said.
Major gold producers, such as Goldcorp Inc. (GG), are devising strategies to compete with gold ETFs as gold prices continue to rise, even as production costs increase and resource nationalism reemerges, says Charles A. Jeannes, President and CEO of the world’s second-largest gold producer by market capitalization.
“The longer the gold price stays up, the more people will be comfortable with it and will assign a higher long-term value to gold when looking at the value of our company. So I’m actually quite bullish about the performance going forward of our stock price relative to the gold price,” Jeannes said.
Jeannes said Goldcorp is growing production by 70% over the next five years, and he said the company’s joint venture with Barrick in Pueblo Viejo in the Dominican Republic will come online in mid-2012, while the Cerro Negro mine in Argentina is expected to produce in 2013. Goldcorp is also paying shareholders a dividend.
“There was an announcement this morning, another 32% increase to $0.045 a month, or $0.54 a year. So we’ve had three increases over the last, just over a year, and I’m quite pleased with the fact that we’ve got the best growth profile in the business, but we’re also able to increase cash going back to our shareholders,” Jeannes said.
Companies that can grow at sustainable rates, have recurring-revenue business models and products with disposable or relatively short life spans are the focus of a resilient, long-term investment approach, says Christian Sessing, CFA, Senior Equity Analyst and Co-Portfolio Manager at AMI Asset Management.
“Our belief is that to grow and to perform well over the long term, you need to perform well over multiple market cycles. We don’t believe in trying to hit homeruns, so to speak, in the good markets only to give it all back in the bad markets. Our goal is to maintain capital in those down markets,” he said.
Sessing likes Stericycle (SRCL), a disposer of medical waste, because of the stability of its recurring-revenue business model. He says SRCL has been able to grow in the mid-to-high single digits on an organic basis with additional growth through acquisitions.
“[Stericycle] has about a 10% market share in the U.S. and has been rolling up small regional players. It has also expanded internationally, and recently broke into new countries that have similar market dynamics to the U.S. in terms of high regulation of medical waste,” Sessing said. “It’s been an interesting name, and a good example of that recurring revenue that we like.”
Business development companies with larger-scale portfolios are able to take part in higher-quality deals within the BDC industry and have more resilient income streams, which offers investors less of a negative impact to earnings versus smaller companies, says Sanjay Sakhrani, a Senior Vice President and Analyst at Keefe, Bruyette & Woods, Inc.
“I think from an investor standpoint, it’s a lot easier to invest in a more liquid name from a stock perspective than in an illiquid one,” Sakhrani said. “One of the problems for smaller BDCs is that they are small from a market-cap perspective, and it makes it tough to attract new investors into the name.”
Sakhrani has chosen Ares Capital (ARCC) as one of his top picks in the sector and he has an “outperform” rating on the company. He describes ARCC as one of the larger companies in the BDC space, which allows it to invest more broadly across the market. Sakhrani says ARCC’s dividend yield is about 10.5%.
“The reason we like Ares is they have a lot of liquidity and they’ve been waiting to deploy that liquidity when things got choppier,” he said. “And it seems to us that the competitive dynamic that existed before has eased somewhat, and you’re seeing a pickup in terms of yield, so I think they can probably deploy that liquidity in a more favorable investing environment today.”
