ETF IYT: Transport stocks are no longer expensive (BATS: IYT)
iShares US Transportation ETF (BATS:BATS:IYT) is an exchange-traded fund focused on the transportation sector. The fund invests in publicly traded US airlines, railroads and trucking companies. IYT is designed to track the performance of its benchmark, which is the S&P Transportation Select the FMC Capped Industry Index. IYT had 52 holdings as of June 16, 2022, and a full sector breakdown is shown below. The fund’s expense ratio is 0.41% and assets under management were $789 million as of June 16, 2022.
As you can see, the largest exposures are air freight and logistics (33%) and railways (31%); also trucking (20%) and airlines (15%). The fund is quite balanced between the different segments of the transport sector. However, IYT’s benchmark uses a cap rule, and this apparently becomes important when you look at the portfolio itself; the two largest holdings together represent 38% of the fund.
The two major holdings are Union Pacific Corp (UNP), a freight railroad that operates 8,300 locomotives on 32,200-mile routes in 23 U.S. states west of Chicago and New Orleans, and United Parcel Service (i.e. UPS) (UPS), an American multinational shipping and receiving and supply chain management company.
IYT has fallen around the same level as the US S&P 500 stock index this year, so we don’t see any noticeable under- or outperformance. It’s worth noting separately though that the IYT typically carries a beta of 1.18x, while net outflows over the past year exceed the current total AUM (see below). Over the past year, $859 million has left the fund, leaving the AUM now at $789 million, as previously mentioned.
Thus, assets under management have practically halved, while the historical beta is actually close to 1.20x. With IYT roughly matching the S&P 500, you could say it’s holding up well. In the past, one might have expected the sector to fare less well. While there have been many supply chain issues caused by an increase in consumer demand post-pandemic, this same increase in consumer demand (which has also contributed to inflationary pressures) has been a backdrop. generally constructive background for transport companies (freight forwarding). Now, as fears grow over unsustainable monetary policy, persistent inflation and near-term recession risks, IYT may be starting to look a lot less attractive.
On the other hand, IYT has fallen significantly this year along with other stocks (iShares reports YTD performance at the time of writing of -24.49%). It is therefore worth assessing the value of the IYT against the price.
IYT’s most recent benchmark fact sheet, as of May 31, 2022, showed a price to earnings of 25.23x and 18.90x, respectively, with a price to book ratio of 4.59x and an indicative dividend yield of 1.51%. Using this information, I calculate an implied expected return on equity of 24.29% and a dividend payout rate of 38.10%.
We can assume that the projected return on equity is probably unsustainable (we should at least start by being cautious); I would also note that Morningstar’s current three to five year average earnings growth rate is estimated at 14.46%. Given that the S&P Dow Jones Indices are projecting one-year future earnings growth of 33.49% (implied by forward and forward price-to-earnings ratios), to align our three- to five-year projection with 14.46 %, we would need a fairly steep decline in earnings growth. I’ll decide to guess 18% in the second year, then 2% thereafter (i.e. anticipated growth, followed by stable growth roughly in line with inflation for the time being).
Keeping the same dividend payout ratio at 38% and assuming no redemptions, return on equity drops to 16% in year six and maintaining the price to earnings ratio at Constant term with today, the implied IRR could be as high as 13% (or 9-10% if we focus on dividend distributions).
The terminal year forward price/earnings ratio is 18.90x in the calculation above, the same as today; the implication is a forward earnings yield of 5.29%. Sounds low, but if you imagine an ERP between 4.20 and 5.90% (a fair risk premium is 4.20% to 5.00%, but you can adjust the upper bound of IYT’s beta by 1.18x), and also assume a risk-free risk of around 3.25% (roughly where the current US 10-year bond yield is), the implied difference is between 2.16% and 3.86% in long-term earnings growth (implied).
Since long-term nominal inflation is likely to be closer to 2% in the long term (in perpetuity), which is unlikely, you can see here that the IYT has some positive asymmetry and assumed upside potential adjusted for long-term inflation. Perhaps the market beta for the fund will also settle over the long term. The 18.90x multiple doesn’t seem particularly rich. However, in year 6 (our terminal year), if we assumed that IYT’s portfolio was aiming for long-term growth of only 2%, the multiple should in theory contract to something like 16.7- 17.5x. This would take our original IRR gauge from 9.61-13.33% to a potential lower 7.10-11.00%; it’s still decent, but suggests a tighter underlying equity risk premium at the lower end.
Overall, while I was bearish on IYT after initially going neutral, after the recent decline I would now be back to neutral on the fund. The fund has fallen since my last post by around -22.01% on a total return basis. Now it appears to offer reasonably good value, but not enough to make the fund look safely undervalued. Additionally, revenue estimates may be inflated; While my theoretical estimates can be considered conservative in some areas, we can also assume that equity risk premia will rise for IYT in the event of a recession or a series of negative earnings surprises within the portfolio (which is itself naturally concentrated).