It’s no secret that America’s infrastructure needs maintenance and capital investment. President Trump and the American Society of Civil Engineers (ASCE) have both highlighted the need for substantial investment. Infrastructure is an investment theme that can rise and fall in short-term popularity based on the feasibility of legislation being passed, but the underlying pressure to spend still remains.
In this vein, let’s take a look at three infrastructure-related stocks to keep an eye on next year.
Caterpillar
The quintessential infrastructure play, construction-machinery maker Caterpillar (NYSE:CAT) faces significant near-term headwinds. As you can see below, a chart of its three-month rolling retail sales shows how Caterpillar is feeling the pinch from slowing demand across many of its end markets:
It was no surprise to see management cut full-year guidance during its recent third-quarter earnings call, and 2020 is shaping up to be another year of declining earnings. That said, the company’s valuation of just 13.5 times forward earnings and its 2.8% dividend yield (management is committed to raising the dividend by high-single-digit percentages for at least the next four years) suggest the downside is limited on the stock. Shares are attractive for dividend-seeking investors, and there’s upside potential from a possible pickup in infrastructure spending.
For investors willing to tolerate some bad headlines in the near future, Caterpillar is an attractive stock to hold for the long term.
Evoqua Water Technologies
The ASCE report card on U.S. infrastructure focused on the $1.1 trillion funding gap in surface transportation (roads, bridges, rail) from 2016 through 2025. But it also highlighted a $105 billion funding gap in water and wastewater, with $150 billion needing to be spent in the same period. This is where companies like Evoqua Water Technologies (NYSE:AQUA) can help.
The company, with a market cap of $2.3 billion, manufactures water and wastewater filtration, disinfectant, and treatment systems. As such, Evoqua is a play on the need for infrastructure investment, both public and private, in an environment of increasingly stringent regulation of public-health matters.
Trading at 31 times forecast earnings and 29 times free cash flow (FCF) for 2020, Evoqua isn’t the cheapest stock in the market (unlike another interesting option, Xylem). But Evoqua has grown earnings at a compound annual growth rate of 14% since 2014, and long-term prospects look good. Evoqua is definitely a stock to keep an eye on.
Norfolk Southern
They aren’t the sexiest stocks to buy, but the major railroads offer investors relative security. After all, they operate as effective duopolies, with BNSF (a subsidiary of Berkshire Hathaway) and Union Pacific in the West, and CSX (NASDAQ:CSX) and Norfolk Southern (NYSE:NSC) in the East.
Aside from trucking, there’s relatively little competitive risk to a major railroad like Norfolk Southern. That said, railroads are definitely stocks that depend on the economy, and end-market conditions are currently deteriorating.
On the other hand, investors in railroad stocks often hold them simply for the certainty of a long-term income stream; Norfolk Southern currently yields 2%. In addition, all the major listed railroads are benefiting from the adoption of Precision Scheduled Railroading (PSR) management techniques — a set of principles designed to improve productivity by reducing the amount of assets needed to run a railroad.
The overwhelming evidence is that PSR works. The case for buying Norfolk Southern stock is based on the idea that, as a later adopter, it can play catch-up to its key rival (and earlier PSR adopter) CSX. If it does, there’s upside potential to the stock.
Investors should keep an eye on how railroads like Norfolk Southern are improving operating margin even as economic growth slows in 2020.
Looking ahead
Next year will be a very interesting one for the markets, and for infrastructure stocks in particular. Growth is slowing, but it looks increasingly likely that doomsday recessionary outcomes will be replaced by a period of sluggish growth.
In such an environment, the market could start to price in a bottoming of Caterpillar’s machinery equipment sales in 2020. Ongoing operational improvements at railroads — largely thanks to PSR — should result in earnings growth at Norfolk Southern. Meanwhile, Evoqua’s underlying demand from utilities and municipalities should remain solid, while the company hopes for a cyclical pickup in demand from the industrial wastewater market.
