Small-Caps to Ride to Rails

08/18/2014 8:00 am EST

Focus: STOCKS

Richard Moroney

Editor, Dow Theory Forecasts

In his Upside Stocks newsletter, Richard Moroney applies his proprietary Quadrix stock rating system-which assesses over 80 fundamental and technical factors-to find opportunities in small-cap stocks. Here, he recommends two stocks in the rail sector.

Founded in 1898, GATX (GMT) has grown into the largest railcar lessor in North America and the second biggest lessor of tank cars. In late July, the US proposed new safety rules for transporting crude oil that would require upgrades for older tank cars by 2017.

Tank cars comprise of about 50% of GATX's North American railcar fleet, so the overhaul could prove costly. GATX says its tank car fleet skews older than its rivals, so it might replace the cars with new ones if the new rules require extensive retrofitting.

The US proposal also seeks to lower the speed limits for trains hauling oil, which could slow the entire North American rail system. Longer transit times are expected to boost overall railcar demand, benefitting GATX.

Strong operating trends should help GATX cope with the new regulations. Cash from operations rose in seven of the past eight quarters.

Utilization rates hover near 16-year highs, and lease renewal rates for 2014 exceeded management's expectations in the March quarter. GATX-scheduled to report quarterly results on July 31, after our publishing deadline-is a Best Buy.

Railcar manufacturer Trinity (TRN) is hitting on all cylinders, reflected by Quadrix scores of at least 95 for Momentum, Earnings Estimates, and Performance. Trinity passed its latest test by reporting June-quarter earnings per share of $1.01, up 94% and exceeding the consensus of $0.77.

Sales surged 39% to $1.49 billion, also ahead of expectations. Trinity has topped consensus profit estimates in 11 straight quarters.

Trinity has rallied 66% so far in 2014, yet its Value score of 78 suggests the shares have more upside. Heavy capital-investment demands have limited free cash flow, though the company has delivered consistent growth in cash flow.

Shares trade at nine times trailing cash flow, a 33% discount to the median of S&P 1500 industrials.

Trinity's tank car orders have slowed as customers await new US regulations for hauling crude oil by rail.

Compared to GATX, the rules proposed in July-requiring about 50,000 older tank cars to be retrofitted by 2017-are an unvarnished positive for Trinity. Trinity expects orders to accelerate once the uncertainty is lifted. Trinity is rated a Best Buy.

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