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Is It Too Late to Invest in Railroads?

Michael Hooper
November 2, 2013

Though most railroad stocks have soared in value since the 2008-09 recession, investors can still find opportunities in this space. These companies' earnings are growing thanks to railroads' pricing power, a rebounding economy in North America, a 4% increase in rail-to-truck (or intermodal) shipping this year, and a 35% increase in the shipment of oil and petroleum products.

Norfolk Southern (NYSE: NSC) recently posted a 23% increase in third-quarter earnings per share, despite a 9% decline in coal revenue. The eastern railroad posted gains in the shipment of autos, trucks, construction materials, merchandise, oil and chemicals.

Union Pacific Corp. (NYSE: UNP), Canadian National Railway (NYSE: CNI) and Kansas City Southern (NYSE: KSU) also saw gains in third quarter activity. Kansas City Southern is the smallest of the three, but owns an excellent North-South franchise with connections to Mexico and Canada. Union Pacific has a diverse western franchise, allowing it to make money in several sectors of the economy. Canadian National Railway is making so much money that it recently announced a share buyback, a 2-for-1 split and fourth-quarter dividend.

The Buffett metric
When Warren Buffett started buying shares in railroads in the mid-2000s, he felt he was a little late to the game, but he invested anyway.

He previously was reluctant to invest because he knew about railroads' awful performance in the 1970s and '80s when there was a lot of consolidation, poor investment returns and bankruptcies, including the end of the Rock Island Railroad in 1980.

To survive, railroads streamlined their operations and diversified their franchises to create new revenues. By year 2000, the surviving railroads were fairly attractive because their valuations had been beaten down, yet their earnings were improving.

In 2010, Buffett paid $100 per share, or 18 times forward earnings, for BNSF Railway. Based on that metric, Canadian Pacific at a 15.56 forward P/E, Union Pacific at a 14.10 forward P/E, and Norfolk Southern at a 13.55 P/E, look attractive today. 

Buffett's 2010 bet paid off immediately: The U.S. Gross Domestic Product grew 2.4% in 2010, 1.8% in 2011 and 2.2% in 2012.

In 2012, BNSF Railway delivered record earnings of $3.37 billion to its parent, Berkshire Hathaway (NYSE: BRK-B), and operating revenues were up 5.39% through the second quarter of 2013.

Railroads are a great barometer of the economy, and 2013 is shaping up to be another positive-yet-slow-growth year for it. U.S. GDP grew 1.1% in the first quarter 2013 and 2.5% in the second quarter. Intermodal volume for the week ended Oct. 19 totaled 264,687 units, up 4.3% compared with the same week last year, and up for the 16th straight week in a row, according to the Association of American Railroads. The increase means there is higher demand for furniture, clothing and manufactured items.

Let's drill down and see which railroad is the best value for the money. We need to look at debt