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How to Invest Like Buffett With the Union Pacific Railroad

By Daniel Ferry - Jul 13, 2014 at 3:08PM

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Why Warren Buffett would approve of an investment in Union Pacific.

Recently my colleague Patrick Morris took a look at Warren Buffett's 2009 acquisition of Burlington Northern Santa Fe railroad, North America's largest railroad by trackage and Berkshire Hathaway's biggest deal up to that point. Despite being an unusual investment for Buffett, it's been a big winner for him, with net income from the railroad more than doubling between 2009 and 2013.

Buffett's still bullish on railroads, and while it's never a bad idea to take investing cues from the Oracle of Omaha, he has made that a bit difficult in this case by buying out every share of his favorite railroad. Short of investing directly in Berkshire Hathaway ( BRK.B -0.59% ), however, independent investors can still follow Buffett's lead by buying shares in Union Pacific ( UNP 0.15% ), a railroad that's virtually BNSF's twin. Perhaps even the better-looking twin.

Photo credit: Union Pacific

A new look at an old business
The first question to ask might be why Buffett is so hot on railroads to begin with, and is he still? Where others may see an old-fashioned, staid industry, Buffett sees the most efficient freight delivery system in the world, a business with insurmountable barriers to entry that feeds the entire North American economy. When he first announced his purchase of BNSF in 2009, Buffett called his move a bet on an American recovery, as virtually any kind of increased economic activity in North America ultimately spurs freight shipments, to the benefit of the railroads.

Since then of course, the economy has come a long way, yet Buffett is still rosy on railroads. Earlier this year, Buffett called the rail industry "a business that has real economic advantages." Buffett cited rail's inherent cost advantages over other form of freight transportation: rail is not only by far the most fuel-efficient way to move freight, but freight trains also require far fewer paid employees per ton of freight than trucks. Buffett concluded that "as long as more goods move from place to place in this country, rails are going to get their share, and it should be a very profitable business."

Meet Union Pacific
Founded over 150 years ago by Abraham Lincoln, Union Pacific is nearly the same size as BNSF, covers similar geographic territory and, therefore, serves similar customers. BNSF and Union Pacific both cover the continental United States from the Pacific to the Mississippi. Western trackage offers more than a few advantages. BNSF and Union Pacific both serve the nation's two largest intermodal ports at Long Beach and Los Angeles, as well as additional major intermodal ports. Union Pacific and BNSF tracks connect these sites of Asian trade directly to major consumer hubs and manufacturing centers in the Midwest, as well as transfer freight onwards to the East Coast. That leaves both railroads in a strong position to benefit from increased cross-Pacific trade, and both have been investing heavily to capture these opportunities.

Both railroads are also tightly geared to the North American energy boom, often directly connecting refineries, power plants, and export terminals on the West and Gulf Coasts with inland Western energy fields. The most explosive growth for Union Pacific has come from the booming shale fields, generating coal and natural gas. While Union Pacific lacks the direct exposure to North Dakota's highly productive Bakken shale formation enjoyed by BNSF, Union Pacific does transfer crude oil originating in the Bakken from BNSF or Canadian Pacific ( CP -1.33% ) rails to its own network, bringing crude to terminals it serves. The company is also investing in connecting its network to crude oil sources outside the Bakken. While Union Pacific does not break out crude oil revenue specifically, it is included in the company's "chemicals" category, which grew 66% between 2009 and 2013. With existing pipeline infrastructure misplaced to serve new Western energy fields and railroads continually investing in new capacity to do so, this trend should continue.

Coal is also a brighter spot for the Western railroads than their Eastern counterparts. Union Pacific and BNSF haul coal from the Powder River Basin in Montana and Wyoming, subbituminous coal that burns cleaner and more easily passes environmental regulations than Appalachian coal. While coal will likely take a progressively smaller share of the electricity market in the United States, it should grow considerably in Asia, and the Powder River Basin's location makes it more competitive to export to Asian markets

You pay for what you get
Union Pacific isn't just geographically positioned to benefit from rising trends in trade and energy consumption, it's also one of the best-run railroads in North America. Union Pacific's operating ratio, a metric commonly used to assess railroads' efficiency, reached a record low of 66% in 2013, comparing favorably to BNSF with 69% and second only to industry-leader Canadian National ( CNI -0.74% ) with 63%. Combine great geographic opportunities and strong management in a business operating in an industry with inherent efficiency advantages and a virtual monopoly over its routes, and you're going to find a high-priced stock.

Union Pacific shares aren't cheap by any measure, selling for more than 20 times earnings and four times books value, yet over the long term railroads have delivered exception returns to investors, and I believe they will continue to do so. And with a dividend that has more than tripled over the past decade, you'll be paid to wait. As Buffett himself said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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Stocks Mentioned

Berkshire Hathaway Inc. Stock Quote
Berkshire Hathaway Inc.
$277.43 (-0.59%) $-1.66
Union Pacific Corporation Stock Quote
Union Pacific Corporation
$240.43 (0.15%) $0.35
Canadian National Railway Company Stock Quote
Canadian National Railway Company
$128.03 (-0.74%) $0.96
Canadian Pacific Railway Stock Quote
Canadian Pacific Railway
$68.88 (-1.33%) $0.93

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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