China’s rail stocks gain steam

At first hearing, the keyword “railway” sounds a little bit dusty. But as a means of transportation, it has good prospects. This is particularly the case for a country like China that is groaning under pollution, especially automobile pollution. That is one of several reasons why Chinese railway stocks look attractive. 

For other reasons, one must look at how interest in railway stocks was restored in the United States. In 2010, Warren Buffet, who uses data about rail transport as an important economic indicator, invested heavily in the sector by buying Burlington Northern Santa Fe Railway. Back then, he paid around $34 billion for the second largest U.S. freight train operator, a steal by today’s standards for his investment company Berkshire Hathaway. Other U.S. railway stocks have also had a very good run since then. 

Currently, a similar investment idea could also pay off in China, assuming the government follows through with its plans to expand the rail network. Since the “Middle Kingdom” anticipates huge traffic growth, as well as increasing pollution, such a scenario appears highly likely. Railways as a safe means of mass transport are seen as one way to mitigate this problem. 

Another government goal is to make the rural regions more accessible. To that end, increased investments in the rail sector have already been announced. Plans call for expanding the railway network to 81,000 miles by 2030.  

Last year, 64,000 miles or railway lines were in operation. Of these, roughly 6.850 miles were high-speed rail links. By geographical area, China’s rail penetration (based on population of 1 billion) is the world’s third lowest, behind only Russia and Canada.  


Chinese rail stock prices gain momentum   

The proposed expansion of China’s railway can also help boost the flagging economy. Railway operator China Railway Corp. has increased its investment budget for the railway system from 720 million yuan to 800 million yuan – some 20 percent more than in 2013. This will also benefit the sector suppliers.  

The renewed investment has sparked more interest and an upward trend in China’s railway stocks. Also, some U.S. investment banks now have a positive view about the Chinese rail sector. Citigroup, for example, is bullish on train manufacturers. The stocks of China South Locomotive & Rolling Stock Corporation Ltd. (CSR), China CNR Corporation Ltd. and Zhuzhou CSR Times Electric Co. Ltd. all have a “buy” recommendation. Citigroup is also optimistic about railway constructors like China Railway Construction Corp. and China Railway Group Ltd. 


Rise in demand  

With interest growing both domestically and internationally, China is actively promoting the export of railway goods and services. China Railway Construct Corp. signed a deal with Nigeria in November worth nearly $12 billion to build a railway along the West African nation’s coast. In connection with that deal, it should also be noted that the planned New Silk Road connecting China, Asia, Africa and Europe via land and maritime routes will also include heavy investment into the railway sector. 

As a result of these positive impacts, the sector should witness growing earnings over the medium- to long-term. Analysts at Citigroup estimate the compound annual growth rate of the earnings per share at 12 percent between 2014 and 2016 of 13 companies in the Chinese railway sector. That sounds promising, even more so as Citigroup’s “buy” recommendations still mostly trade under their longer-term valuation averages measured on a price earnings and a price-to-book ratio. On an absolute basis, the two mentioned railway construction companies, which have an estimated market share in China of 40 percent to 45 percent each, make the best impression. According to Bloomberg, China Railway Construction Corp. carries a price earnings ratio for 2014 of 7.1 and a current price-book ratio of 0.98. China Railway Group has corresponding figures of 8.5 and 1.03, respectively. 

Bottom line: The investment story of the Chinese railway sector sounds promising. The stocks in the sector have established mid-term upward trends. As long as these trends continue, it makes sense to hold on to these investments. However, the risks – with a view toward the high level of corruption in China – should not be underestimated. Further, corporate governance in China still leaves much to be desired. Past experience, unfortunately, reveals many cases where top management did not act in the best interest of the external shareholders but more to their own benefit instead. Also as a protection against such negative surprises, positions should be secured with stop-loss limits.