Rail stocks vs. airlines: Which potentially offers more opportunities for investors?

[AUDIO LOGO] * If you had a look at the transportation sector this summer, you would have seen the airlines mostly outperforming the rail stocks. But that trend seems to be changing as we get further into the fall. Joining us now to discuss, Juliana Fairclough, Vice President, Portfolio Research at TD Asset Management. * Juliana, great to have you back on the program. Give us the lay of the land, trains versus planes. * Yeah. Thanks for having me. So as you mentioned, it's been a volatile year for those two pockets within industrials and within transportation. If we look at performance year to date, I think we've brought in a chart that shows both of those segments have at this point underperformed the broader market. * If we look at the US market-- * The S&P 500 would be the gray line. And then we've got the airlines and the rails. Yeah, at one point, I think as we were saying off the top, the airlines outperforming. But now a different story. * Exactly. So the path has been very different. You see the airlines, if you'd held them until July you were up over 40%. The path between those two end markets has been really different. * So on the one hand with airlines, we know that travel demand has been really robust. I think anecdotally we can all see that airfares are quite high. That's pretty positive for the airlines. In Q2, they grew earnings over 90%, the US airlines kind of broadly. Delta reported last week and they grew earnings about 35% in Q3. * The flip side of that is the rails, where we've been in more of a freight recession. That's what the rails will tell you. That's what the truckers will tell you. And from an earnings perspective, it's been a bit more challenging for the rails. Q2 earnings, the US rails declined something like 15% or 16%. So again, that compares to over 90% for the airlines. So very diverging paths for two parts of the transportation industry. * You use the term freight recession. What are we talking about here? Because broader in the economy, we've been talking about the shift from goods to services. Is there a bit of that playing into this idea of a freight recession? * Absolutely. And I think that that concept of the consumer switching from goods to services is very, very clearly played out between airlines and rails. So when I say freight recession, I really mean rail volumes have been declining or negative year-over-year for most of the year in 2023. A lot of that's driven by intermodal volumes. * By intermodal we really just mean kind of consumer facing volumes that the rails will move across Canada or across the US. And those have been negative for a couple reasons. The first would be that shift from goods to services, that consumers are not spending as much on furniture anymore and instead, they're spending on travel and they're booking flights with Air Canada. * The other would be inventory destocking. It's pretty related to the goods to services shift. But we know a lot of the big retailers built up huge inventory balances over 2021 and 2022. And it's taken some time to move through that in the system as consumers have spent a little bit less on goods. * So we did have that airline sector outperformance earlier this year. It's been a tough market across the board for a lot of stocks in the past several weeks. But at the same time, when you talk about airlines, it can be a tricky business. Are we starting to see some of that appear, some warnings from the airlines? * So you're right that it can be a tough sector or industry, I guess, to invest in. And if we look over the long term, I mean, in the last five years, I think we have a chart there as well showing the airlines have underperformed quite materially relative to the rails, that orange line, and the broader market, the gray line. * Of course, maybe it's not fair to look at that chart specifically. It includes COVID. That's a very unique shock for the airlines. But even pre-COVID, if we look at the five years from the end of 2014 to the end of 2019, a similar picture. Airlines have kind of gone nowhere as a sector, whereas the rails have outperformed and the market itself has been up over a five-year period pre-COVID. * There's a few reasons for that. And I think it highlights an interesting case study in terms of what fundamental investors look for in terms of a quality industry. Obviously, both the airlines and the rails are very capital intensive. It costs a lot of money to build a rail network. It costs a lot of money to start an airline. There's a lot of regulatory hurdles for rails and airlines to jump through. There's pressure from labor, from unions. * But there's a few key differences that I think are interesting to highlight in terms of structure. That would be barriers to entry, competitive intensity, and customer switching costs. * Let's take a few of those. I would think, I mean, from my point of view, I'm not in a position to either to start an airline or a railway, that the barrier to entry would be high. But not so for airlines if you do a deeper dive. * Exactly. So if you think about barriers to entry, you're right, it's very expensive and there's a lot of regulatory pressure in order to start an airline or a railway. I think what's different about the rails is there's a pretty unique infrastructure barrier, where there is-- I mean, it's almost inconceivable to think of a new coast to coast rail network being laid down in Canada or the US. The amount of land requirements, work with communities that all of that would require is so massive that it creates an insurmountable barrier to entry for the rail network. * Airlines, it is difficult to start an airline but it's not impossible. * Got the money, you buy some planes. Maybe you can make a go of it. * Exactly. Over the last couple of decades, we've seen new entrants in the space. We've seen a big boost and growth from low-cost carriers. So there's Ryanair in Europe. In Canada, we've seen Flair and Swoop and some of these smaller low-cost carriers move in. So the barriers to entry are just structurally a bit lower for airlines. * When it comes to the rails-- and obviously, you're laying out a thesis here where over the longer term it seems to be a bit more of a stable business-- they seem at the same time, though, to be very much tied to an economy. Is that always the near and medium term or even longer term risk that there is a cycle to the economy and when it goes into a downturn and a recession, the rails probably wouldn't perform? * For sure. I mean, within the industrials landscape in general, a lot of those companies are tied to the broader market cycle. It's a sector where the correlation to PMIs, purchasing manager indices, which is kind of a measure of the economic cycle, is the highest for industrials than any other sector. So the whole space moves with the broader economy. * Rails are no different. They tend to grow volumes alongside GDP growth. They do have a long-term history of generating positive pricing. And if we compare that to the airlines, where air travel tends to be some multiple of GDP growth, in general-- if we're in decline, people are traveling less, companies are sending people on less conferences and business travel-- pricing can be a little bit more volatile for the airlines. And that can go negative more so than it can for the rails. * That makes a lot of sense actually. If I'm feeling a little discomfort about the economy, perhaps my own job security, might not buy a TV but probably not going to jump on a plane either. * Anything else we need to think about when investors are doing their homework on these two parts of the industrial space, the rails and the planes? * I think that the competition and customer switching cost dynamic is pretty interesting to explore as well. So on the competitive side, since Kansas City Southern was acquired by Canadian Pacific earlier this year, there's now six class I rails. Sounds like a lot and sounds like a competitive dynamic. The reality is that most of the rails compete in a regional duopoly. We've got the two Canadian rails. There's two East Coast rails, two West Coast rails in the US. * In the airline space, we know it's quite a bit more competitive. If you type in, I'd like to fly from Toronto to New York, a whole list of flights come up across a bunch of different airlines. And that kind of feeds into that switching cost dynamic, where it's very easy for me to choose between airline A, airline B. If I fly on one airline and I have a terrible experience, I have options A, B, and C for the next time I fly. It can be a more fickle customer relationship. * The rails have sort of longer term dynamics with their customers. Partly that's because they're not necessarily dealing with an individual consumer, but a lot of that is kind of structural partnerships between manufacturers or international shippers that have long-term relationships with the rails that makes it difficult for customers to move from Canadian National to Canadian Pacific, for example. [AUDIO LOGO]

[MUSIC PLAYING]