Playing the Transportation Space Through an ETF

As the global recovery continues, consumer confidence rises, and exports from China grow, one way investors can play the rebound is through a basket of transportation companies. At first glance, the transportation companies may seem like they operate in commoditized spaces. However, many of the larger transporters have shown themselves to be high-quality investments. In fact, no less of an investor than the legendary Warren Buffett--whose  Berkshire Hathaway (BRK.A), (BRK.B) acquired U.S. rail giant Burlington Northern Santa Fe in February 2010--views railroads as having distinct and sustainable competitive advantages and functioning as a long-term bet on the U.S. economy and on continued demand for imports from Asia and for coal. It is obvious that many transportation firms have developed high barriers to entry through major capital investments and networks that are difficult, if not impossible, to replicate. And the rail companies in particular have begun earning their cost of capital--something that they had not done in decades.

A Leading Indicator for the U.S. Economy
The domestic transportation sector is widely perceived to be leading indicator of the U.S. economy. While some traffic is less economically sensitive, such as agricultural products, much of the demand for what transportation companies carry correlates to economic activity. The sector is benefiting from a clear economic rebound, growing consumer confidence, and increased exports from China, which has loosened its export policy. Meanwhile, Middle East turmoil has driven fuel prices up. As a result, some transportation companies are expected to reinstate fuel surcharges.

U.S. Railroads: More on Track Than Ever
Rail companies possess upgraded physical plants, to which they have made significant investments in during the last decade. Improved on-time performance has restored shippers' confidence in carriers' abilities to deliver freight when needed. Some rail firms, such as  Union Pacific (UNP), have repriced legacy contracts that previously had precluded fuel surcharges or the pricing power that the rails have enjoyed recently. Increased demand should continue, including for coal for power generation, container imports from Asia, and ethanol-related traffic. Rail firms also should reap rewards from core price increases and streamlined operations. The biggest risk is a potential prolonged U.S. economic downturn followed by declining fuel prices steering volumes back to trucking. Other risks include irrational trucking pricing, the possibility of Congress reregulating railroads' rates and work rules, as well as company-specific issues like asbestos liabilities at  CSX (CSX) and liabilities associated with hazardous-materials spills at Union Pacific.

Truckers and Freight Forwarders Migrate Toward Higher-Margin Businesses
Truckers continue to enjoy a solid rebound in demand, particularly in intermodal volumes. Asset-intensive player  J.B. Hunt Transportation Services  (JBHT) has worked to diversify its service portfolio away from the solely commoditized aspects of the trucking industry and has proved itself capable of passing on fuel-price surcharges to customers. Asset-light, third-party logistics providers  Landstar System  (LSTR) and  C.H. Robinson Worldwide  (CHRW) have created wide economic moats through proprietary information systems and networks of customers and suppliers. Like rail companies, trucking firms are exposed most to a cyclical U.S. economy. They also face constant uncertainty over the reliability of third parties, such as railroad firms, executing their services.

UPS and FedEx Continue Delivering Growth
Overnight delivery firms  United Parcel Service (UPS) and  FedEx (FDX) have greater overseas exposure (22% of UPS' revenues and 28% of FedEx's revenues), which is critical to growth. Both firms have constructed powerful networks and consistently have grown revenues through expanded service offerings (becoming a bigger, stickier part of clients' operations) and higher-return, less-than-truckload freight. In the medium-term, however, both companies are exposed to greater competition in the less-than-truckload segment. Both always are at risk of labor disruption, although given several ongoing issues, that uncertainty appears to be far greater at FedEx.

Rebounding Passenger Volumes and Consolidation in Airlines
Although publicly traded airlines largely carry people instead of freight, they also are exposed to some of the same drivers as companies that tote goods, including fuel prices and the broader macroeconomy. U.S. airlines have had a great run of late, with soaring stock prices that have been driven by growing passenger volumes on effectively flat ticket prices, along with a wave consolidation.

Five Transportation-Related Exchange-Traded Funds Investors Can Consider
Here are five ways for investors to tap the transportation sector through an ETF:

 iShares Dow Jones Transportation Average Index (IYT) (0.47% expense ratio)
This is far and away the largest and most liquid transportation exchange-traded fund. It's also very concentrated, tracking a price-weighted index of just 20 companies. American railroads represent 31% of IYT's assets, while trucking companies make up another 22% of fund assets and overnight delivery firms comprise 18%. IYT also holds freight-forwarding firms and a handful of airlines. Fully 65% of IYT's assets are invested in companies with economic moats, which Morningstar's equity analysts define as sustainable competitive advantages. Union Pacific is the fund's largest holding, followed by FedEx, CSX, and C.H. Robinson.

 SPDR S&P Transportation ETF (XTN) (0.35% expense ratio)
This upstart ETF, which began trading in January 2011, is still small and thinly traded. Unlike IYT, it is equally weighted, which means it's more volatile but benefits from the longer-term outperformance of small-cap stocks, plus the discipline of the forced rebalancing that builds in a buy-low, sell-high effect. Investors should note that XTN is more diverse than IYT (40 names versus 20), with a much smaller exposure to railroads (15% of the portfolio), and higher exposures to trucking (35%) and airlines (26%). Air freight & logistics companies make up 19% of the fund. Also, unlike IYT, XTN holds car-rental companies like Dollar Thrifty , Hertz  and Avis Budget (CAR).

 Guggenheim Shipping  (0.65% expense ratio)
Guggenheim Shipping aims to capitalize on growing investor interest in global shipping by offering exposure to a diversified portfolio of industry participants, which generate at least 80% of their profits from maritime shipping. We caution investors that this subsector of transportation--represented by dry-bulk cargo shippers and container shippers--is more commoditized than others. At the same time, the fund has very specialized exposure, and fully 13 of its 30 holdings--or more than 40% of assets--are names that trade on foreign exchanges. As a result, it would be hard for a U.S. investor to assemble a portfolio with all of the ETF's holdings.

 Guggenheim Airline ETF  (0.65% expense ratio)
For investors looking solely for exposure to airlines, the narrowly focused and concentrated Guggenheim Airline is an intriguing option. The modified equal-dollar-weighted ETF is heavily weighted to U.S.-domiciled air carriers (representing just greater than 67% of assets). It has 23 holdings, 11 of which are listed in the U.S. Investors should beware, however: Of those 11 U.S.-listed airlines, Morningstar's equity analysts cover nine of those companies and assign "very high" or "extreme" uncertainty ratings to all nine carriers.

 Direxion Airline Shares   (0.55% expense ratio)
This ETF began trading in December 2010 and is still small and very thinly traded. With just 15 companies in its portfolio, it's even more concentrated than FAA. FLYX only holds companies that trade in the U.S., so as such, it's much more of a pure play on domestic air travel (although it also holds several foreign airlines that trade on U.S. exchanges).

Given the transportation sector's role as a leading indicator for the economy, investors also can consider  Industrial Select Sector SPDR (XLI) (0.20% expense ratio), whose performance is highly correlated to IYT and likely would be highly correlated to XTN once it establishes a sufficient track record.

In all of these cases, these ETFs are very concentrated bets on a very narrow market segment. As such, we believe these funds make most sense as satellite holdings at best in a diversified portfolio.

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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock Asset Management, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.