Railroad Stocks: the Little Sector That Could

As the market tanks, shares of Burlington Northern and others keep tooting.

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A Burlington Northern Santa Fe (BNSF) engine pulls a train loaded with coal in Chicago, Illinois.

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Free-falling home prices and logjammed credit markets have hammered most stocks, but the railroad industry has chugged right along in 2008. While the Standard & Poor's 500 index is down more than 9 percent this year, the S&P's railroad sub index is up roughly 7 percent.

So how have railroads been able to largely dodge the housing-related trauma that has crippled others? First off, while railroads have indeed carried a lower volume of building materials, surging demand for commodities—such as grain and coal—has picked up the slack. "The housing slowdown has taken its toll on the railroad sector, but they are so diversified right now with what they are transporting," says David Silver, an analyst at Wall Street Strategies. "Weakness in the lumber and wood that they do for the housing is more than offset by the strength in coal...and strength in grain."

Globalization, which has more intimately connected the United States to far-off parts of the world through trade, has also benefited railroad companies. Although they may be cheaper to produce, goods manufactured in countries like China have to be moved longer distances than those made domestically in order to reach the U.S. consumer. "When you start getting global sourcing as opposed to [goods] having been made in Ohio...the trade is very pro rail," says Anthony Hatch, an independent railroad analyst at ABH Consulting in New York.

Higher fuel costs—while squeezing consumers—have actually helped railroads by giving them an edge over their less-fuel-efficient competitors: trucks. "The rails generally operate with roughly 30 percent cost advantage to trucks because of more efficient fuel costs," says Nevin Chitkara, a portfolio manager of the MFS Value fund, which holds shares of railroad company Burlington Northern Santa Fe. "As fuel costs have gone up, that competitive advantage has become more important." Chitkara adds that the weak U.S. dollar has also helped the industry by increasing demand for U.S. coal exports.

Finally—and perhaps most important—through industry consolidation and by eliminating excess track, the railroads have regained pricing power. "The rails can now raise rates," Hatch says. "The supply-and-demand metrics have gotten tighter." In addition to simply charging higher rates, the railroads can also pass their higher fuel costs along to customers in the form of a surcharge.

Arthur Hatfield, a transportation analyst at Morgan Keegan, says the railroad sector's good fortunes should last a while. "I expect the strong performance in the stocks to continue," Hatfield says. "Without a doubt, it comes down to an industry play at this point in time, and I think all of them have different reasons why you can invest in the companies."

Considering investing in railroads? Here are three companies to look into:

Burlington Northern Santa Fe: With 32,000 miles of track in 28 states—predominantly in the West—and two Canadian provinces, Burlington Northern is the second-largest U.S. railroad company. The company transports more grain than any other U.S. railroad and moves a great deal of coal as well.

"The company has benefited from very strong growth in coal shipments, grain exports, and surging imports of consumer goods from China," Adriana Posada, a portfolio manager of the American Beacon Large Cap Value Fund, which owns Burlington Northern shares, said in a statement. "The impact of this strong volume growth has been to tighten capacity, creating a favorable pricing environment that should remain in place because there is only limited railroad track available." And Posada isn't Burlington Northern's only fan. Warren Buffett's Berkshire Hathaway owns a big stake in the company as well.

Silver projects Burlington Northern's 2008 revenue to increase about 9 percent from the previous year, with earnings per share climbing roughly 15 percent. The company's shares are up about 10 percent this year so far.

CSX: CSX, the third-largest U.S. railroad operator and the biggest mover of coal east of the Mississippi River, has a 21,000-mile rail network in the eastern United States and Canada. Kevin Kirkeby, a Standard & Poor's analyst, says that CSX's balanced mix of business makes it the most attractive player in the rail sector. "They are moving the same types of goods as everybody else. However, they are not particularly overweight or overly exposed to one particular area," Kirkeby says. "It's the much more evenly spread portfolio of business that they have that is an appeal to us." Kirkeby says that CSX's efforts to reduce costs make it attractive as well.