Benefiting From the Dow Theory Buy Signal

In a recent article, we highlighted the latest Dow Theory buy signal. Rather than repeat the details of Dow Theory and explain the signal here, we recommend reading the original article. In this post, we want to address specific stocks that can benefit from the signal.

Dow Theory relies on the principle that both production and transportation are important. This is a logical relationship. If factories are producing goods and no one is buying the output, inventory will stack up because there will be nowhere to ship the completed products to. In that environment, transportation companies will be underperforming. If trucking companies are busy shipping products around the world but factories are no longer producing goods because orders have declined, transportation companies will soon face a downturn. In a healthy economy, both producers and transportation companies should be doing well. This was the insight Charles Dow built on to develop his market timing model now known as the Dow Theory.

Dow considered the broad stock market to be bullish when both the Dow Jones Industrial Average and Dow Jones Transportation Average are making new highs as they are now.

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A sell signal will come when both indexes break down. A signal is only confirmed when both indexes are moving in the same direction.

This insight can also help make stock selection for a bull market somewhat easier. We can focus, for example, on industrials or transportation companies to benefit from a Dow Theory signal. If we attempt to identify potential winners in the industrial sector, we will need to anticipate which products will be attractive to consumers. This can be a difficult task. But we know that no matter what is produced, transportation companies will need to transport the completed products to market. Transportation companies should also benefit from delivering raw materials to producers. In a bullish environment, such as the one expected to follow a Dow Theory buy signal, transportation companies can be among the biggest winners.

To find potential winners in this sector, we screened for stocks offering income with a history of earnings and analysts’ expectations of earnings in each of the next two years. We found five companies.

Just as in Dow’s day, railroads are a potential buy. Among the most promising railroad stocks are American Railcar Industries, Inc. (Nasdaq: ARII), FreightCar America, Inc. (Nasdaq: RAIL) and The Greenbrier Companies, Inc. (NYSE: GBX).

ARII designs and manufactures hopper and tank railcars. The company also leases hopper and tank rail cars. This operating segment leases a fleet of more than 10,000 railcars. Tank cars were in heavy demand a few years ago to meet the needs of the shale oil industry. New technologies such as vertical drilling and hydraulic fracturing opened up new oil fields. In particular, hydraulic fracturing or fracking is the process of injecting liquid at high pressure into subterranean rocks or boreholes to force open existing fissures and extract oil or gas. This technology allowed oil companies to drill in areas where extraction had been too expensive before. Many of the new oil fields were far from the existing pipeline infrastructure. This made rail the most cost effective way of moving oil from fields to refineries.

Railroad stocks benefitted from the oil boom as long as it lasted. The downside to that relationship can be seen in the chart below. The railroad industry index crashed as the price of oil fell.

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Railroads have begun to move higher as oil seemed to find a bottom. This may be due to the compelling valuation of stocks in the sector.

ARII is trading with a price-to-earnings (P/E) ratio of 12.7. Over the past seven years, a timeframe that captures both the boom and bust of oil, the average P/E ratio of the railroad industry was 18.2. ARII is more than 40% undervalued based on the historic average. It may take time to return to this level, but as investors wait, they will be rewarded with an annual dividend of $1.60. The 3.4% yield appears to be safe with the company’s earnings and cash flow from operations being sufficient to maintain the payout.

RAIL is also a railcar manufacturer. The company also exports its manufactured railcars to Latin America and the Middle East. This makes RAIL a trade that can benefit from a rebound in the global economy. If oil prices do rebound, and there are signs that the commodity has bottomed, RAIL could increase sales to oil producing nations in Latin America and the Middle East. The recent deal between OPEC and non-OPEC producing nations appears to be bullish for oil. If the reduced production goals are met, the demand for oil is expected to exceed supply for the first time in years. With increased prices, producing countries would be able to reinvest in neglected infrastructure and RAIL could profit.

The stock offers investors a dividend yield of 2.2%. This is twice the average yield of the stock. Earnings are expected to contract over the next few years but the company has historically generated high levels of cash flow from operations.

GBX has more diversified operations. The company is a leading international supplier of equipment and services to the freight rail transportation markets. In addition to designing and building railcars in North America, Brazil and Europe, the company also builds and markets marine barges in North America. Recently, through a European manufacturing operation, GBX began delivery of US-designed tank cars to Saudi Arabia.

In October, the company entered into an agreement with Astra Rail Management GmbH to form a new company, Greenbrier-Astra Rail, which will create an end-to-end, Europe-based freight railcar manufacturing, engineering and repair business. This combination is expected to be completed during 2017. GBX is also a leader in freight railcar repair, refurbishment and retrofitting services in North America through a joint venture partnership with Watco Companies, performing management services for over 268,000 railcars. The company also owns a lease fleet of over 9,000 railcars.

GBX is expected to report EPS of $3.37 this year but earnings are expected to fall to $1.87 next year. Even next year’s earnings are sufficient to maintain the company’s annual dividend of $0.84. The yield of 2% could be attractive to income investors.

All three of these rail stocks are relatively small companies and could be attractive to larger companies as takeover candidates.

Trucking companies also offer potential gains although they offer less income than the railroads.

ArcBest Corporation (Nasdaq: ARCB) provides freight transportation services and integrated logistics solutions worldwide. The company provides motor carrier services through North America including Canada and Puerto Rico. Its Premium Logistics segment provides expedited freight transportation services to commercial and government customers; premium logistics services, such as deployment of specialized equipment to meet line haul requirements; and domestic and international freight transportation with air, ocean, and ground service. ARCB is well-diversified with other divisions including an Emergency & Preventative Maintenance segment offering roadside assistance and maintenance management services for commercial vehicles through third-party service providers. The company’s Household Goods Moving Services segment provides third-party transportation, warehousing, and delivery services to consumer, corporate, and military household goods moving markets. ARCB operates approximately 4,200 tractors and 20,800 trailers.

ARCB pays an annual dividend of $0.32, providing a yield of about 0.99%. Analysts expect the company to report EPS of $0.89 this year, $1.57 next year and $1.90 in 2018. An industry average P/E ratio of 21 provides a price target of $39.90 based on expected earnings.

Universal Logistics Holdings, Inc. (Nasdaq: ULH) provides transportation and logistics solutions in the United States, Mexico, Canada, Colombia, Europe, and internationally. The stock offers a dividend yield of 1.6%. Its price target is $26.46 based on expected EPS of $1.26. ULH is thinly traded and if you trade this stock, consider using limit orders to enter and exit positions.

Transportation stocks could be among the biggest winners in a growing economy. This was true 100 years ago and is true today. The recent Dow Theory buy signal makes these stocks especially interesting right now.