The sector Warren Buffett is backing for another 100 years

It is often said that railroads were at the heart of the development of the American economy, peaking in 1916 with 254,000 miles of track and 1.8 million employees — more than any other industry¹.

Less well known is the fact they made up most of the oldest US index, the Dow Jones Transportation Average (DJTA), better known as the Dow Transports, which was first compiled on 3 July 1884.

It started with 11 companies, but after 140 years, countless mega mergers and the addition of industries that the original founders could barely even conceive of, for example car rental companies or ride-sharing businesses , it still only numbers 20 stocks.

The composition of broader equity markets has changed beyond all recognition since then. But even though they are now dominated by capital-light industries such as technology rather than capital-intensive ones such as manufacturing, the health of the transport sector remains an important barometer of economic health.

In Berkshire Hathaway’s most recent letter to shareholders, chairman Warren Buffett claimed this will still be the case in the extreme long term. He owns railroad operator BNSF in his portfolio, saying that a century from now, it will “continue to be a major asset of the country and of Berkshire. You can count on that.”²

Performance

The long-term performance of the Dow Transports index offers clues as to why it continues to attract serious investors.

In 1964, it first broke 200. By 1987, it was at 1,000. It carried on its steady rise to close above 9,000 on 10 November 2014. At the end of May, it stood at 15,238. Perhaps surprisingly, it is one of the few major US indices that investors cannot fully replicate with a passive fund.

So, while the index may be small in terms of the number of listed companies, the investment opportunities are significant – more so if you take a selective approach.

There are good transportation companies with asymmetric risk/reward profiles – a core part of our ‘up/down’ process – namely the long-term outlook is good but the current share prices don’t reflect that potential.

US transportation stocks have had a tough time over the past three to four years, with the sector in aggregate trading significantly below pandemic-era lows relative to the market.

We think this is primarily driven by excess capacity, which was added during the consumer goods/inventory boom around Covid, and underwhelming demand.

In our opinion, we are largely through inventory de-stocking, but there’s limited evidence of any meaningful restocking activity yet.

Cuts to earnings expectations have been widespread. For example, Knight Transportation, a well-run trucking business that we don’t currently own, has seen its 2024 sell-side earnings estimates fall by more than 50%: soft demand and excess supply have weighed heavily on pricing.

We do see selective value in the space and are currently invested in two transport stocks, Saia, an LTL (less-than-truckload) company, and Norfolk Southern, a railroad business, which is one of the 20 companies currently in the index.

Saia

Saia has been a longstanding position for us and has grown from a regional LTL carrier into a national player. Over the years it has significantly improved its operating performance and gained market share.

Last year a major competitor filed for bankruptcy and as a result, Saia was able to pick up a significant amount of market share without compromising on operating performance or price. Saia was also able to acquire some real estate through the competitor bankruptcy process, which should help it realise its long-term growth plans.

This year, there have been some concerns about underlying growth in the sector: LTL volumes tend to be more focused on the manufacturing sector, where growth has been sluggish. Consequently, there was a pull-back in the stock.

However, in recent weeks we have seen encouraging updates from the company: it is opening around 15 new terminals (including some acquired through the competitor bankruptcy process) and shippers appear to be steering more volume its way.

We see a long runway for growth (ultimately driven by an expanding geographic footprint and continued improvements in operating performance), although in the short term we are mindful of the somewhat softer-than-expected backdrop.

Norfolk Southern

East-coast railroad operator Norfolk Southern is a recent re-entry into the portfolio.

Early this year it was the focus of an activist investor campaign, which, while not completely successful, saw the company overhaul and improve its board of directors.

This also included major changes to management compensation and the appointment of an external chief operating officer with deep industry expertise who joined from the recently combined Canadian Pacific Kansas City railroad.

We think these developments are sufficient to catalyse operating improvement, which tends to be closely correlated with profitability. That improvement, to us at least, does not appear to be reflected in the shares.

The importance of being selective

There are many different factors affecting transportation stocks and, in our opinion, taking a broad top-down view is not the correct way to generate investment returns in the space.

Businesses and the conditions they operate in constantly change. So, while like Buffett we think it pays to take a long-term approach when investing in transportation businesses, forgive us if we don’t commit to one for the full century.