The Harriman Book Of Investing Rules. Stephen Eckett

      The transport sector

      Introduction

      The transport sector accounts for only 3% of European stock market capitalisation, but between 10 and 15% of European GDP. The difference represents the continental European operators which are still state or municipally owned. There are also thousands of small operators in segments such as trucking. Privatisation has only really fully happened, Royal Mail excepted, in the UK.

      The sector splits into unrelated sub-sectors, including: airlines, infrastructure (e.g. airports, seaports, railways), passenger transport (e.g. trains, buses), shipping, and logistics. Each sub-sector has a totally different market structure and dynamics. Airlines and shipping are global businesses, urban buses local. Some are consolidated, others fragmented. All face legislation and regulation risks.

      1. Buy cyclical stocks - particularly airlines - when next year’s P/E ratio is 50x, sell when 5x.

      The lower the P/E ratios for airline stocks, the greater the stock market’s conviction that current consensus earnings forecasts are near the top of the cycle and therefore about to start falling. Low P/E ratios point to potential downgrades ahead as the cycle turns down. They suggest it is a good time to sell. High P/E ratios for airline stocks are caused by negligible earnings - even losses - and tend to exist around the bottom of the cycle. It is often a good time to buy as the cycle is near the bottom and may be close to turning up.

      2. The share prices of regulated business are anything but boring and predictable.

      Regulated businesses are perceived as dull, boring and predictable monopolies, and not the sort of businesses to have profits warnings. Not true. Shareholder returns are hugely geared to company management achieving demanding targets set by their regulator. Management excellence, rather than competence, is the requirement. Investment, before this is proven beyond reasonable doubt, can be hazardous.

      3. Recently privatised businesses acquire disastrously.

      Cash generative, and with a desire to diversify away from their often unexciting core businesses, these companies are in too much of a hurry to make acquisitions overseas of similar businesses. BA with its investment in US Air, BAA with Duty Free International, AB Ports with American Port Services and Stagecoach with Coach USA are all examples in the UK transport sector, and all were damaging to shareholder value. There are as many examples in other sectors.

      4. Americans will stop travelling overseas at the slightest excuse.

      Bombing of Tripoli 1986, Gulf War 1991, US economic slowdown, weak dollar, bombs in London, Foot and Mouth in Europe 2001, you name it, American tourists stop travelling outside the US. The stock market always underestimates this and a surprisingly high number of industries depend on them.

      5. Bottom line sensitivity to a 1% change in GDP growth, a $1 per barrel move in the oil price, and a 1% price increase must be defined.

      Transport companies are highly geared operationally. They have high fixed costs with marginal revenue often going straight through to the bottom line. They are very sensitive to GDP growth and their high operational gearing means they tend to exaggerate changes in GDP, both up and down. Surprises, both pleasant and unpleasant, therefore originate nine times out of ten from macro economic developments outside management control.

      6. Be aware of the extended investment cycle.

      The economic cycle is often exacerbated by too much new capacity being ordered/built on the back of over-confidence during the good times, which, given the long time lags involved in construction, often then comes on stream as the cycle is starting to turn down.

      7. GDP growth has a multiplier effect on the propensity of things to move around more.

      Most transport sub-sectors are growing above GDP growth because the propensity of goods and people to move about tends to grow at a multiple of underlying GDP of anything between 1.5x and 6.0x, depending on sub-sector. The logistics industry is growing even faster as companies out-source to third party providers, functions previously undertaken in-house.

      8. The IT revolution is having a big impact on certain sub-sectors.

      The IT revolution has created enormous opportunities in certain transport sub-sectors. Airlines for example, by encouraging on-line booking through their websites, are able to dis-intermediate travel agents who have traditionally charged 7-8% commission on ticket prices. Logistics companies that have best harnessed the new technology have established enormous competitive advantage over those who have not in the management of global supply chains, both B2B and B2C.

      9. Barriers to entry are critical: these dictate pricing power.

      The supply side revolution in the US and the UK means good businesses are soon copied, bringing competing new entrants and lower returns. Today’s niche becomes tomorrow’s commodity. Scarcity of suitable land makes ports, airports and railways powerful local monopolies and, if unregulated, safe investments geared to economic growth.

      10. Detailed analysis of y-o-y change in a company’s net cash position is neglected at one’s peril.

      Companies have huge leeway to make their profits what they want them to be. Any sensible FD will maintain a stockpile of provisions available for release as and when required. Earnings growth is therefore a meaningless number because it is measuring the difference between two numbers both of which have been manipulated. Cash is fact, not opinion, and therefore more difficult to manipulate. Analysts focus on P+L, rarely on detailed cash flow despite the recent requirement for a company to reconcile movements in its net debt.

      ‘All great bull markets are rooted in easy money . . . The corollary is that a bull market cannot persist in the face of tightening liquidity.’

      Martin Barnes