No. 1 Railroad Company is a Top Rebound Candidate in 2016

Most sectors of the S&P 500 have been caught in the market sell-off lately, with all except utilities in the red for the year.

The market rout has left one staple of American progress down 12% year to date. But it has been battered, along with its entire sector, for nearly a year. Shares now trade for a 30% discount to their long-term P/E ratio, while numerous catalysts are lining up for a rebound. 

Relief on the Horizon for Rail Stocks

Weak commodity prices (especially for coal), falling industrial output and strength in the U.S. dollar have taken a major toll on railroad stocks. The Dow Jones U.S. Railroads Index has fallen roughly 40% in the past 12 months.

Union Pacific (NYSE: UNP) — the No. 1 railroad company in the United States with 32,000 route miles running across 23 states in the western two-thirds of the country — is no exception.

UNP Map

Earlier this month, UNP slid 3.5% in one day after it reported dismal fourth-quarter results. While pricing was 3.5% higher year over year, volume sank 9% and earnings per share fell 19%.

Shares are now 45% off their 52-week high, set in February, and trading for just 12.1 times trailing earnings. That’s 30% below the five-year average P/E of 17.4. Meanwhile, a number of short-term and long-term catalysts could be about to send bargain-priced UNP higher.

For starters, management seems to be taking advantage of the stock’s discount by aggressively buying back shares. The board authorized a $9.5 billion stock buyback program for the next four years, which at current prices is more than 15% of the shares outstanding.

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While volumes on industrial products, which account for 17% of freight revenue, fell 16% in the fourth quarter, they could get a boost as the spring construction season begins. Construction materials account for more than a third of segment volume and should do well this year thanks to a relatively healthy U.S. economy and low interest rates.

At the same time, Union Pacific’s automotive shipments (11% of freight volume) look strong. During Q4, shipments were up 8% year over year. A record 17.5 million vehicles were sold in the United States last year. This trend should continue as IHS Automotive predicts U.S. auto sales will hit record levels in the next two years. 

Looking a bit longer term, the agricultural segment (19% of freight volume) and the chemical segment (18% of volume) could get a significant boost from the La Nina weather phenomenon. Australia’s Bureau of Meteorology says there is a roughly 50% chance of La Nina taking shape in the second half of 2016. 

La Nina typically brings drought conditions to parts of the United States, along with flooding in the Southern Hemisphere. If that happens, it could result in higher crop prices and higher fertilizer volume.

Even discounting the potential for a La Nina year, we are likely to see higher agricultural demand and fertilizer use in the long term thanks to the world’s growing population. Already, the World Bank is warning of massive food shortages in coming decades.

Finally, the rail company achieved record train size performance and terminal productivity in 2015, which helped improve its operating margin to 37.4% — nearly a full percentage point better than in 2014. This marked the 10th consecutive year of stronger operating profitability — a trend that will pay off when volume improves.

Earn a 56% Annualized Return While Reducing Risk

I want to take advantage of these catalysts and a potential rebound in Union Pacific. But given the current state of the market, I’d also like to add a little downside protection to my trade.

One of the best ways to do this is with a covered call strategy, which involves buying at least 100 shares of the stock and immediately selling a call option against the position. The call option obligates you to sell the shares at the option’s strike price if they are above that level when the option expires. In return, you receive a payment, which is known as a premium.

The income received from selling the call option is yours to keep no matter what. If the stock declines, your shares will decrease in value, but you have the option premium to counter the loss. In other words, if shares do happen to fall, you’re better off selling a covered call than simply holding the stock.

With UNP trading at $69.06 at the time of this writing, we can buy 100 shares and simultaneously sell one UNP March 72.50 Call, which is trading around $1.29 ($129 per contract) for a net cost of $67.77 per share. That puts our cost basis just over 1% above the 52-week low and means shares can fall almost 2% before we experience a loss.

If UNP closes above the $72.50 strike price at expiration on March 18, our shares will be sold for that price. In this case, we will make $3.44 in capital gains, plus the $1.29 we received for selling the calls and the February dividend payment of $0.55. That’s good for a total return of $5.28 per share and represents a profit of 7.8% over our cost basis of $67.77. Since we’d earn that in 51 days, it works out to an annualized gain of 56%.

If UNP does not close above the strike price on expiration, we’ll keep the shares and can write more call options against the position while waiting for a rebound.

A covered call strategy can actually be used on almost any stock you hold, provided you own at least 100 shares. And with the precarious state of the market, traders would be wise to look into it to generate extra income and protect downside risk. As I mentioned, when stocks fall, the covered call seller is in a better position than the traditional stockholder. Plus, you can use this simple strategy to bring in an extra $3,000 a month.