Buffett on right track: Buying rail stocks

By Michael Brush

Warren Buffett has been working on the railroads -- a good sign that you might want to, as well.

Buffett recently built an 11% position in North America's largest rail company (by market capitalization): Burlington Northern Santa Fe (BNI, news, msgs). And that's not the only railroad in his sights.

Railroads aren't exactly new technology, but the stocks of these companies have tripled over the past three years. Here's why they appeal to Buffett:

• It's no easy thing to start a railroad, so the existing companies have a great deal of control over prices.
• Despite their recent strength, you can make a case that rail stocks are contrarian investments -- and Buffett loves betting against the crowd. Many Wall Street analysts have neutral ratings on the rail stocks. Lots of investors dislike them because of forecasts of an economic slowdown. So they're placing huge bets that the five biggest companies in the group are about to get derailed.

Here's the odd part, for a Buffett investment, anyway: These stocks aren't cheap. Virtually all of the big rail companies are trading at or near 52-week highs. And they were even before news of Buffett's interest.

For that reason, some investors aren't expecting big short-term payoffs from the stocks. "I wouldn't be surprised to see them level off here for a while," says Don Hodges, a value-oriented investor whose rail stock positions have helped his Hodges Fund (HDPMX) post award-winning, five-year annualized returns of 18.7%.

So what do you get with these stocks if they're not cheap? Voluminous cash flow -- another of Buffett's favorite things. Here are a few reasons the cash should keep rolling in:

• Trade with China and India means plenty of goods will need to be moved from West Coast ports to the rest of the country for years to come.
• Elevated oil prices mean that the country is using and transporting more coal.
• High fuel costs and new limits on how much time truck drivers can spend behind the wheel are hurting truckers, the railroads' chief competition.

Cautious investors may wait to buy rail stocks until after the Buffett hoopla cools down, but investors who buy now can still expect gains of 25% to 45% in the big rail companies over the next three years or so, believes John Buckingham, another value investor who owns rail stocks in the Al Frank Fund (VALUX) he manages.

• Video: Buffett takes the train

The biggest North American rail companies are Burlington Northern Santa Fe and Union Pacific (UNP, news, msgs), which dominate the Western states; Norfolk Southern (NSC, news, msgs) and CSX Corp. (CSX, news, msgs), which are the big players in the East; and Canadian National Railway (CNI, news, msgs), one of the major railroads north of the border.

Barriers to entry

A "bedrock" Buffett principle is that companies must have a "durable competitive advantage" that gives them barriers to entry and pricing power, says John Reese, of Validea Capital Management, who has done extensive research on market gurus like Buffett to learn how to recreate their investment styles.

Railroads have this because potential newcomers would have to pay so much to set one up. Burlington Northern, for example, owns more than 20,000 miles of track in the United States and Canada, and it owns or leases more than 85,000 rail cars and 23 facilities dedicated to handling distribution of automobiles. Now, it's using that position to force rate increases on customers. Its earnings were up more than 25% last year, thanks in part to a 15% boost in freight revenue -- two thirds of which came from price increases. CSX revenue grew 8% last year, and the company estimates that 60% of that came from price increases.

The long and short of it

A lot of investors don't agree that rail stocks can still do well. You can tell, because there is such a big short position in rail stocks. (To go short, investors borrow stock and then sell it, hoping it falls so they can replace it cheaper later on for repayment to the lender.) Short positions in CSX, for example, are the highest they have been in the past five years, says technical analyst Phil Erlanger of Erlanger Squeeze Play.

The shorts are betting that recent weakness in rail company pricing power and a decline in shipping volumes will continue. But a survey of shippers published last week by Credit Suisse (CS, news, msgs) analyst Jason Seidl suggests there's still so much demand that rail companies will maintain their pricing power. "What remains to be seen is whether the rails can continue to maintain pricing if an economic downturn persists," Seidl says.

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