Buffett's Railroad Purchases Stay on Track

Warren Buffett has never felt the need to stay on top of technological breakthroughs. Despite holding a close friendship with Bill Gates, the man rarely uses a computer. Heck, he hardly ever uses a calculator, for that matter.

The Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) chief has made a name for himself by investing in easy-to-understand companies that don't depend heavily on technological innovation. Known to some as "the Oracle of Omaha," Buffett has made billions of dollars investing in no-thrill industries such as soft drinks, newspaper, underwear, and ice cream. Some onlookers, claiming there was no room for boring, stodgy industries in an economy that was so in love with the latest and greatest, criticized him for shying away from dot-coms and high-tech stocks during the heyday of the Nasdaq boom. Not surprisingly, Buffett ended up with the last laugh.

So it should come as no surprise then that Buffett has found a new love for one of the oldest, slowest-changing and most boring industries in America: railroads.

Last week, Berkshire disclosed that it had purchased another 7.85 million shares of railroad behemoth Burlington Northern Santa Fe (NYSE: BNI). Berkshire now owns more than 60.8 million shares of the Texas-based railroad company, a stake currently worth more than $5 billion. Berkshire also holds smaller positions in railroads Norfolk Southern (NYSE: NSC) and Union Pacific (NYSE: UNP). The new share purchases came as Berkshire exercised call options that it acquired earlier this year.

Why is Buffett suddenly attracted to railroads? All three companies trade at or near their all-time highs, yet Buffett usually tends to pounce on out-of-favor stocks that have gotten bogged down by pessimism. To add to the confusion, Buffett himself had found railroads unattractive investments for decades.

Just this year, at the Wesco (AMEX: WSC) shareholders' meeting, Buffett's right-hand man, Charlie Munger, said:

Warren and I have hated railroads our entire life. They're capital-intensive; heavily unionized, with some make-work rules; [and] heavily regulated. [And they have] long competed with a comparative disadvantage versus the trucking industry, which has a very efficient method of propulsion and uses free public roads. Railroads have long been a terrible business and have been lousy for investors.

But the times, they are a-changin'. Several shifts in the marketplace have given railroads an advantage they haven't seen since the days when robber barons like Jay Gould ruled the industry. As Munger explained when he added to his comment: "We did finally change our minds and invested. We should have done it two years ago, but we were too stupid to do it at the most ideal time."

Let's look at some of the reasons why Buffett may have changed his frame of thought:

• Rising diesel prices hurt many modes of transportation, but they affect railroads about one-quarter as much as they do truckers.
• As oil and natural gas prices continue to rise, coal has become an increasingly more efficient source of energy, and railroads are about the only way to haul coal over long distances. That's especially beneficial for railroad companies that specialize in making coal cars, such as FreightCar America (Nasdaq: RAIL).
• As America increases trade with Asia, more and more goods need to be transported by rail across long distances.
• A recent ruling that put lower caps on the total number of hours that truck drivers can spend behind the wheel puts railroads at an advantage over truckers, who are the top source of competition for the rails.
• Railroads are becoming more competitive over trucks, with double-stacked railcars and computer-guided systems to ensure increasingly efficient travel.

The industry as a whole also has incredibly high barriers to entry. Ever try to build a cross-country railroad? It wouldn't be easy -- or cheap. Burlington Northern lays claim to approximately 32,000 miles of rail track throughout the United States and Canada, and it's using this stronghold to raise prices at a greater rate than expenses climb. The results have been enticing: Burlington has been able to grow net income by more than 32% per year for the past three years. So much for a ho-hum industry.

Add it all up, and you get a classic Buffett investment -- easy to understand, high barriers to entry, a durable competitive advantage over the competition, and increasing pricing power.  

And don't expect Buffett to slow down anytime soon. Berkshire Hathaway has already informed the SEC that it intends to acquire more than 25% of Burlington Northern in the future.

Until that happens, check out this related Foolishness:

• Be Better Than Buffett
• The Optimistic Prediction of Warren Buffett
• Buffett's Words of Wisdom