• This article was first published in MoneyWeek magazine issue no 990, 13 March 2020
The protracted row over the ballooning costs and uncertain benefits of the HS2 high-speed rail project has obscured the bullish long-term growth outlook for the overall rail industry. Whether it’s a case of freight trains improving their efficiency to become a more competitive option for shippers than lorries, commuters ditching the car in favour of trains, or “flight shaming” causing people to embrace “slow travel”, railways seem to be recapturing some of the excitement of the “glory days” of the pre-WWI years and the late 19th century. This in turn has major implications for the companies involved in the sector.
Rail freight’s recovery
Goods trains are perhaps the least glamorous part of the rail industry. Slow, noisy and tied down to particular routes, they seemed at one point to be facing an existential threat from flexible, faster lorries, which now carry nearly three-quarters of freight by volume in the US and a similar proportion in other major economies. At the same time the decline of the coal industry in Britain and America hurt demand from what had been one of rail’s most reliable and lucrative customers.
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The good news is that freight rail is starting to make something of a comeback. Part of this is due to an increase in demand as trade has expanded. While coal may be declining, “increases in the amount of commodities, chemicals and crates of general goods mean that there has been a big growth in the volume of freight in recent years”, says Jim Wright, manager of the Premier Miton Investors Global Infrastructure Income Fund. Global trade growth has been so strong that there has been a rise in the number of ports, especially on the west coast of North America.
However, rail companies have also managed to dramatically improve the efficiency of their operations thanks to a “laser-like focus on taking out costs and reducing inefficiencies”, says Wright. Much of this is due to “precision railroading”: a management philosophy that focuses on making freight networks more efficient by operating on fixed schedules (like passenger trains) and combining container and general merchandise trains. Railways have also found that they can cut both costs and the speed of transport by running longer trains, which reduces the number of individual journeys that they have to make.
The greener option
Cost isn’t the only area where rail freight has an advantage over road haulage. Rail has a much lower carbon footprint. As a result, there has been a big push within Europe to get firms to switch from road back to rail, leading to “significant freight growth”, says Wright. The road-haulage industry is also facing a recruitment crisis, with the sector unable to find people who are willing to replace the drivers who are retiring in droves. While some in the road-haulage industry are pinning their hopes on driverless lorries, these are “a long way away”.
Overall, the prospects for rail haulage appear rosy for the next two decades, with Wright expecting annual freight growth “in the high single-digits for up to the next two decades”. Of course, coronavirus-related disruption could lead to a temporary downturn in global trade, hitting rail freight volumes. However, any impact is likely to be limited to the “short term” and won’t be strong enough to halt the structural upswing.
The growth of metropolitan services
When it comes to transporting people rather than goods, commuter and metropolitan rail services within cities and suburbs have experienced a sustained increase in passenger numbers over the past 20 years. Railway historian and transport expert Christian Wolmar thinks that this has two main causes.
Firstly, there has been a big increase in population growth in urban areas. This has helped because rail works best in more densely populated areas; trains take up much less room per passenger than private cars.
Wolmar also believes that there is strong evidence that we are starting to see “peak car”, with overall car-ownership rates starting to fall, especially among the younger generations. Part of this shift away from cars stems from changes in lifestyle and concerns about cars’ role in contributing to global warming and reducing air quality. However, it’s also due to the simple fact that larger and more crowded cities have produced an increase in traffic congestion, which in turn makes urban car journeys longer and less pleasant.
Ride-sharing won’t ride to the rescue
While some people argue that the future of urban transport lies in ridesharing services such as Uber, or even self-driving cars rather than trains and light rail, Wolmar is extremely sceptical. He argues that the available evidence suggests that while some people may be taking Uber rather than catching a bus, such services are too “expensive” for anything other than short journeys, while fully autonomous self-driving cars are “still decades away”. In any case, when it comes to the problem of congestion, new technologies will end up creating “as many transport problems as they solve” since they do nothing to reduce the number of people on the road.
Ivo Weinöhrl, senior investment manager of the Pictet-SmartCity Fund, goes even further and argues that services such as Uber, along with other transport solutions such as cycling schemes, might actually increase demand for rail transport since they help solve the “last mile” problem.
In his view, one of the big issues that used to discourage people from taking rail transport was that “you could take a train for eight to ten miles, but still find yourself inconveniently far from your ultimate destination when you arrived at the station”. However, thanks to the improved “micro-mobility”, this isn’t such a problem anymore.
It looks as though passenger numbers in urban areas will continue to climb around the world. One particularly encouraging sign is that even Americans, traditionally seen as averse to mass transit, “are starting to become a lot more comfortable with taking the train”, says Weinöhrl. There is a “surprising amount of metro investment in the US, especially on the... coasts, as well as specific areas like Salt Lake City”. The United Kingdom is also expected to follow the global trend of rising numbers of train commuters.
Passengers flock to intercity and high-speed services
The number of longer intercity rail journeys is also climbing steadily. With transport accounting “for over half of global oil consumption and nearly a quarter of CO2 emissions”, governments are trying to encourage people to use more environmentally friendly forms of transport instead of using the car or flying, says Jerry Thomas, Head of Global Equities at Sarasin & Partners. In some cases people are cutting down of their own accord, with evidence that “flight-shaming” has led to falling passenger numbers at some airports.
Thomas says governments around the world are noticing that people are most willing to switch from the car or the plane to the train for distances that are longer than 100 kilometres (km), but take less than five hours. One way to make the train more attractive than the plane is to cut journey times by increasing speeds. For example, “when the Madrid to Seville high-speed line was opened in 1992, the proportion of people making the journey by train shot up from 33% to 84%”.
As a result, governments around the world have made huge investments in high-speed trains. Much of it has taken place in China, which built 19,000 km of high-speed rail track between 2013 and 2018. While the period of “transformational hypergrowth” is likely to come to an end as the network matures and consolidates, the amount of rail track is still expected to expand by 5% a year through to 2025. This means that within five years another 16,000km of rail will have been laid.
Europe’s network is expanding rapidly
Even if the growth of high-speed rail in China starts to moderate, Thomas thinks that other countries are likely to pick up the slack. Over the last three decades, Europe’s countries have made a concerted effort to boost high-speed rail, with the network growing at a rate of 9% a year.
Not only does Europe have “ambitious plans to maintain growth of high-speed rail in order to shift even more traffic from planes to trains”, but Brussels is also aiming to develop “a Trans-European High Speed Rail Network, which will require harmonisation of rail gauges, electrification and signalling”.
India, one of the world’s largest economies, is another market where high-speed rail has “substantial growth potential”, says Thomas. The government plans to “add over 13,000km of high-speed rail lines”, though progress is being hampered by “bureaucracy and the need to acquire private land”.
More broadly, “the low cost of borrowing and political pressure to invest in infrastructure to support economic growth” should ensure that governments around the world continue to invest in high-speed rail.
Thomas is a little more sceptical about Maglev trains, seen by many as the future of ultra-high speed rail. This technology uses magnets to enable the trains to float slightly above the tracks, greatly reducing friction.
Despite higher theoretical speeds, the reduction in travel times is only significant enough to justify the extra cost “if it is used to connect cities at least 500km apart and at those distances air travel is still more competitive”. Still, Thomas thinks that it would be foolish to write the technology off completely as Maglev is starting to appear on a limited scale in South Korea and Japan, while China “is expected to open a new Maglev line”.
The subsectors worth researching now
The main way for investors to get a piece of the current rail boom is to invest in those firms that directly move people and goods. Given his bullish views on freight, it should come as no surprise that Miton’s Jim Wright has several American freight railways in his portfolio.
He argues that freight railways are a particularly attractive from of transport because their huge networks and capital infrastructure can’t be easily replicated, which means it is very difficult for competitors to enter the market. That makes them natural monopolies.
Just as freight railways will do well from the rising amount of freight carried, operators of passenger rail services will benefit as more and more people use trains, says Esmé van Herwijnen, Responsible Investment Analyst at EdenTree.
However, while many train operators are listed on the stockmarket, others are harder to invest in because they are either run by the government with no private involvement or have the government as a controlling shareholder (in which case the interests of minority shareholders may be neglected). This is particularly the case in much of continental Europe. In addition to investing in the network operators it makes sense to consider companies that manufacture the trains and railcars. Not only is there a “big backlog of orders” for powerful, technologically advanced trains, but in addition “most orders involve recurring main contracts”, says Pictet’s Weinöhrl.
As a result, companies not only receive a large upfront payment, but then also get another stream of income over the next 25 years to maintain them. In many cases the total maintenance payments can be worth as much as the trains themselves, effectively doubling the potential revenue as well as insulating the companies from any sudden downturn in demand.
There are also opportunities further down the supply chain. For instance, several companies have carved out a profitable niche selling equipment such as safety systems – taking advantage of the fact that the high degree of regulation creates effective barriers to entry for potential rivals – or even individual components. Weinöhrl also thinks that dedicated price-comparison websites, which help consumers pick out the best deal from among the wide range of possible fares and routes, will do well.
The rail stocks to buy now
One of Jim Wright’s favourite stocks is Union Pacific Railroad Company (NYSE: UNP). Union Pacific was founded in 1862 and is the second-largest freight railway in the US, with over 32,000 miles of track. Between 2014 and 2019 it grew earnings per share by nearly 50% (or around 8% a year).
It has also managed to make a return on capital expenditure, a key gauge of profitability, of around 15%. It trades at a very reasonable 14.9 times 2021 earnings, with a dividend yield of 2.8%.
Wright also likes East Japan Railway Company (Tokyo: 9020), the largest of the seven private railway companies in Japan. It serves the northeast of the country and operates both freight and passenger rail, including the high-speed trains in the region. East Japan Railway has enjoyed solid if unspectacular growth of around 2% a year over the past five years and has a return on capital of around 10%. It plans to expand earnings by using its expertise in new markets, such as Indonesia, and by making more money from hotels, shops and other real estate near its stations. It is on a 2021 price/earnings (p/e) ratio of seven, making it a good-value play.
Ivo Weinöhrl of Pictet-SmartCity Fund likes Alstom SA (Paris: ALO), which manufactures a wide range of trains, including France’s high- speed TGVs and Eurostar trains, along with related equipment. Revenue increased by 43% between 2014 and 2019, while management has improved the return on capital to 10%.
Alstom will grow organically owing to the increasing demand for high-speed trains, while it has also agreed to buy Bombardier’s rail division, which should reinforce its market position. Given all this, the stock looks very reasonable on a 2021 p/e of 18.3.
Another major train manufacturer worth considering is the German engineering multinational Siemens AG (Frankfurt: SIE). Siemens isn’t a pure play;the rail division (Siemens Mobility) only accounts for around 15% of Siemens’ net income. However, this is likely to increase since the rail business boasts a bulging orders book. The company as a whole has enjoyed solid annual revenue growth of around 4% a year over the past few years. It also looks attractively valued at 10.6 times 2021 earnings with a solid dividend yield of 4%.
Jerry Thomas, head of global equity at Sarasin & Partners, recommends Knorr-Bremse AG (Frankfurt: KBX), which makes braking systems for both trains and commercial road vehicles, with trains accounting for around 60% of revenue. Knorr-Bremse should benefit from both the boom in freight and a greater demand for safety. Sales have grown by 32% over the last five years and are expected to increase by 10% a year over the next few years. A return on capital of 25% also more than justifies a valuation of 18 times 2021 earnings.
Thomas also likes Wabtec Corporation (NYSE: WAB).Wabtec provides brakes and other safety components for passenger and freight trains, as well as equipment enabling certain train functions to be partly automated. Wabtec is trying to boost profits by moving into Russia, India and other parts of Asia. It has had some success improving profit margins by reducing costs. With a growing backlog of orders its future prospects seem assured, which suggests that it is conservatively valued on a 2021 p/e of 10.6.
Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.
He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.
Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.
As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.
Follow Matthew on Twitter: @DrMatthewPartri
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