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ETF Specialist

Can the Hard-Hit Transportation Sector Get Back on Track?

Interested investors may consider this ETF, the largest that holds U.S. transportation companies, which have been battered by sagging commodity prices.

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Transportation stocks have taken a beating thus far in 2015. While much of the rest of the U.S. stock market has posted decent performance, rails, airlines, truckers, and other transports have taken steps backward, for several different reasons. Airlines have sagged amid investor fears about greater carrier capacity hindering airline companies' profitability, while railroads have been hit hard by slumping commodity prices and reduced energy-related volumes, particularly in coal, which has been hit hard by falling Chinese demand and a glut of supply from Australian companies. Making matters worse were labor disputes at intermodal ports on the West Coast, which hampered the western railroads' intermodal carload volumes.

Many of the dynamics that have pressured transportation companies this year are temporary in nature and certainly have the potential to reverse. In the meantime, many transports are companies with economic moats, which means that Morningstar's equity analysts believe they have distinct and sustainable competitive advantages. The transportation sector reflects the health of the overall economy. Investors interested in getting exposure to it should consider  iShares Transportation Average (IYT), which offers concentrated exposure to the transportation industry. It's the largest transportation-related exchange-traded fund available, and it holds 20 rail companies, trucking firms, delivery-services companies, freight forwarders, airlines, and marine transport firms.

This fund has a certain amount of company-specific risk, as its top 10 holdings account for about two thirds of assets. Its top three holdings constitute more than 28% of this ETF's assets.

Many transportation firms have developed high barriers to entry through major capital investments and networks that are difficult, if not impossible, to replicate. Some 68% of IYT's assets are invested in companies with Morningstar Economic Moat Ratings, signifying sustainable competitive advantages.

Because this ETF is exposed to the broader economy, it is more volatile than the broader market. During the past 10 years, its standard deviation of 20.0% is meaningfully higher than the 14.7% standard deviation that the S&P 500 has posted in that same time frame.

Fundamental View
The domestic transportation sector is a widely perceived leading indicator of the U.S. economy. While some traffic is less economically sensitive, such as agricultural products, much of the demand for transportation companies' freight correlates to economic activity.

Morningstar's equity analysts give wide moat ratings to all six North American Class I railroads, which include the four Class I carriers held in this ETF. Morningstar's equity analysts have confidence the rails will continue to increase their profitability, and, as a result, their returns on invested capital. Rail companies (23.5% of IYT's assets) remain the low-cost option by far, where no waterway links origin and destination, offering quadruple the fuel efficiency of trucking per ton-mile of freight. Even for goods that can be shipped by truck, the railroads charge an estimated 10% to 30% less than trucking containers in the same lane. These cost advantages have been bolstered in recent years by significantly upgraded physical plants and improved on-time performance that has restored shippers' confidence in carriers' abilities to deliver freight. Over the longer term, increased demand should continue, including coal for power generation (especially overseas), container imports from Asia, and ethanol-related traffic. Some railroads' domestic coal volumes have fallen amid lower natural gas prices and higher coal stockpiles at U.S. utilities. The biggest risk to the rails is a U.S. economic downturn, followed by declining fuel prices steering volumes back to trucking. Other risks are irrational trucking pricing and any reregulation of railroads' rates and work rules.

Meanwhile, the two major overnight delivery firms (which represent 21% of the fund's assets) have refined their portfolios to increase margins and capture more of their clients' shipping spending.  FedEx (FDX) in particular has expanded its network by purchasing assets in ground delivery and less-than-truckload freight, and its massive international shipping network is a clear competitive advantage, while  United Parcel Service (UPS) benefits from tremendous package volumes and the use of a single network instead of parallel air and ground operations. Both FedEx and UPS are working to boost profitability by expanding high-margin ground operations and (in FedEx's case) realigning international express operations.

Some large trucking companies (19% of assets) have created economic moats through cost advantages and network effects (in the case of  J.B. Hunt (JBHT) and  Landstar (LSTR), which have strong shipping networks), while others, such as  Con-way (CNW), lack moats and face greater cyclicality as their business models have strong price competition, minimal switching costs, and high fixed costs.

Recently declining fuel prices only have a short-term impact on transportation companies. Most firms have fuel surcharge programs in place to pass through changes in fuel prices. In the short run, carriers enjoy a margin benefit for several quarters from rapid declines in fuel prices because of the time lag in adjusting surcharges to shippers. However, over the long term, surcharges make fuel price movements profit-neutral. The lag can go the other way as well: When fuel prices rise as they have in recent weeks, transportation firms can experience temporary headwinds. In the medium term, lower fuel costs likely will steer more volumes away from the rails and toward truckers.

Portfolio Construction
IYT aims to replicate the performance of the price-weighted Dow Jones Transportation Average Index; it is the oldest U.S. stock index and contains 20 of the largest, most-liquid U.S. transportation stocks. Four holdings are rail companies, four are truckers, two are overnight delivery companies, two are asset-light freight-forwarding firms, two are maritime shippers, and one is a car rental firm. Finally, the fund holds five airline companies (which together make up about 15% of IYT's assets); five of the 10 smallest equity positions are airline companies. The index's price weighting approach can lead to some odd index weightings. For instance, railroad company  Kansas City Southern (KSU), with a market cap of $10.7 billion, has nearly as large of a weighting in this ETF's index as  Union Pacific (UNP), whose market cap is $89.9 billion. The Dow Jones Transportation Average Index typically adds and deletes components on an as-needed basis, although index changes are not frequent. When one component is replaced, the index committee reviews all index components. The committee has a policy of only adding reputable companies with sustained growth and a lot of investor interest.

IYT's 0.43% expense ratio is in line with other industrials subsector ETFs but is relatively high compared with  Industrial Select Sector SPDR's (XLI) 0.15% fee or  Vanguard Industrials' (VIS) 0.12% expense ratio.

IYT is by far the largest and most-liquid transportation ETF. IYT's closest competitor is the equally weighted SPDR S&P Transportation ETF (XTN), which charges 0.35%. The more diverse XTN holds 48 companies, including names in some subsectors that IYT avoids, such as car rental companies.

Another transportation-themed ETF is Guggenheim Shipping (SEA), which holds 25 dividend-paying maritime shipping firms. SEA charges 0.66%.

For overseas industrials exposure, investors also can consider iShares Global Industrials ETF (EXI) at 0.47%.

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Robert Goldsborough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.