CSX Corporation (CSX) has enjoyed a breathless rally in the last two years and has thus outperformed the market by a wide margin. During this period, the stock has rallied 138% whereas S&P has advanced 35%. The big question is whether there is further upside for the stock.

CSX provides rail, rail-to-truck, and intermodal transport services. The company started with 13 miles of track, which has grown to a current network of 21,000 miles across 23 states. Railroad stocks comprise an interesting group of stocks thanks to the strong competitive advantage they enjoy. As it is extremely costly to create a network of routes that connect various parts of the continent, there are essentially prohibitive barriers to entry to potential new competitors. As a result, railroad stocks enjoy a wide moat in their business.

CSX currently exhibits strong momentum thanks to favorable trends in its business. In Q2, the company exhibited strong growth in the revenues from almost all the freight categories. Moreover, thanks to its cost-cutting initiatives, it has managed to enhance its operating margin for four consecutive years, from 28.5% in 2014 to 35.6% this year. Furthermore, the company benefits from a meaningful decrease in its tax rate this year thanks to the recent tax reform. Overall, the company is poised to grow its earnings per share by more than 50% this year and post record earnings this and next year.

All the above factors help explain the relentless rally of the stock in the last two years. However, this rally has led the stock to trade at a current P/E ratio of 20.4, which is much higher than its 5-year average P/E of 16.9. On the one hand, the rich valuation can be partly justified by the strong momentum of the company. On the other hand, as soon as the company begins to decelerate, its P/E ratio is likely to contract towards its average historical level. If this occurs within the next three years, the stock will incur a 6.1% annualized drag due to P/E contraction. Consequently, investors should be aware of the significant downside risk of the stock whenever it faces unforeseen headwinds in the several freight categories it engages in.

Moreover, the results of CSX are largely determined by the state of the economy, as higher product volumes are transported during favorable economic periods. At the moment, the domestic economy is at its best point in history, as it has expanded for nine consecutive years and has thus led the unemployment rate to almost all-time low levels. Nevertheless, as a recession has not shown up for almost a decade, it may very well show up in the upcoming years, particularly amid rising interest rates, which tend to suppress the total amount invested in the economy. Whenever a recession shows up, it will have a severe impact on CSX.

First of all, it will adversely affect the transported volumes and will thus exert downward pressure on its earnings. In addition, it will exert great pressure on the P/E ratio of the stock. As a result, the stock will incur a double hit; lower earnings and a lower P/E ratio. This pattern was evident in the Great Recession when CSX saw its stock price plunge 70% in less than a year. While there are no signs of an upcoming recession on the horizon, investors should remember that economic downturns are unpredictable and thus they can show up any time in the years ahead. Due to the rich valuation of CSX, investors should not ignore this risk factor of the stock.

Final Thoughts

As long as the domestic economy continues to grow, even at a slow pace, CSX is likely to continue to reward its shareholders. Given its strong business momentum, investors who purchase the stock even at its current all-time high will probably be able to make a short-term profit. On the other hand, whenever the economy takes a turn for the worse, CSX will have huge downside potential due to its leverage to the state of the economy and its current rich valuation. Therefore, we advise investors with a long-term perspective to avoid the stock unless they have great confidence that a recession will not show up in the upcoming years.