Investors making tracks to railroad stocks

Strong fundamentals and an apparent lack of competition bring billionaires on board.

Published May 29, 2007

OMAHA, Neb. - Freight railroads and their investors can feel confident no new railroads will try to create a competing network - the cost is too high.

So the six major players in the industry will continue helping businesses connect with suppliers and customers for years to come.

That enduring competitive advantage, combined with strong demand from shippers, is part of why billionaire Warren Buffett's company, Berkshire Hathaway Inc., invested in three freight railroads. But investors who are thinking about following Buffett will have to determine whether strong business fundamentals or Buffett excitement drove the recent rise in rail stocks.

The three railroads companies Berkshire invested in - Burlington Northern Santa Fe Corp., Union Pacific Corp. and Norfolk Southern Corp. - are trading near their 52-week highs. And the same is true for the three other major North American freight railroads Berkshire didn't buy: CSX Corp., Canadian National Railway Co. and Canadian Pacific Railway Ltd.

The run-up in rail stock prices started last month when Berkshire disclosed its BNSF stake and Buffett said he'd bought into railroads.

It continued this month when Berkshire revealed its investments in UP and Norfolk Southern and another billionaire, Carl Icahn, disclosed his company had invested in CSX.

Edward Wolfe, an analyst with Bear Stearns & Co., said in a research report that the high-profile rail investors have helped generate new interest in the industry.

"In addition to continued strong pricing and positive long-term secular demand fundamentals, we believe the strong run for the group so far in 2007 has been driven by newfound investor interest in the railroads, " Wolfe said in a research note.

But billionaires aren't the only thing driving railroad stocks higher.

The most important factor in railroads' current and future profitability is the high cost of building a rail network, which makes new competitors extremely unlikely, said Randy Cousins, an industry analyst with BMO Capital Markets in Toronto. Cousins said he believes Buffett recognized some of the competitive advantages the major railroads enjoy.

"I think he (Buffett) sees some powerful trends that are working for the railroad industry that aren't going to go away overnight, " Cousins said.

Besides the near-monopoly power that major freight railroads enjoy, Cousins said, railroads are helped by the fact that more businesses today need supplies delivered from afar, and shipping by rail is less expensive than shipping by truck.

Most of the major freight railroads stand to benefit from the ethanol boom as more plants become operational in grain growing states such as Nebraska, Iowa and Illinois. The fuel additive is generally shipped by rail, and some ethanol plants will likely pay railroads to deliver grain to them.

Plus, railroads haul a diverse mix of products and commodities and can send locomotives wherever they are needed if the demand picture changes.

"The locomotive power doesn't care what's behind the train, " Cousins said.