US railroad operators are back on track

Despite being marginalised on the US stockmarket, American railroad companies have proved themselves stellar performers. What has caused this renewed growth?

Back in the 1890s, Charles Dow created a series of market indices designed to track the performance of the US stockmarket. The Dow Jones Industrial rose to become the world's most widely followed index. Dow himself, however, was a great believer in watching the Dow Jones Transport Index. Originally containing nine railroad and two other transport-related companies, this index measured the state of the backbone of the American economy. If the rails were healthy, so was the rest of the economy.

Today, the index contains 20 companies, of which just four are railroad operators, the remaining being split between trucking and airline businesses. But despite having been marginalised on the stockmarket, American railroad companies have been proving stellar performers during recent years. Share prices of the four largest listed companies have roughly doubled since 2004. In the past five years, the S&P 500 Railroad index (which is made up of the shares of these four top US carriers) climbed at an annual rate of 19%, or almost five times the rise of the broad-market S&P 500 index.

The chances are that this sector has even further to run. It was once considered a dying sector, but railroads are all of a sudden a high-margin growth business. America's rail transport volumes have increased 25% since 2002, with two factors crucial to this growth spurt: the increasing amount of coal being hauled across the country for energy production, and the fact that railroads are critical for distributing the ever-larger imports of goods from Asia.

Cleaner coal-burning technology and the political desire to become less dependent on foreign oil makes it likely that the US power sector's demand for locally produced coal will increase further. Also, with China and other parts of Asia having become the world's sweatshop, the amount of goods entering the US through ports will continue to grow. Trucks could compete for this growing business, but railroads are able to transport the same amount of goods for a third of the energy that a truck would use. Moreover, road congestion has doubled in the US since 1990.

This strong growth comes in a sector where competition has been virtually eliminated. Mergers reduced the number of big railroad operators to two in the East and two in the West. Unlike airlines, this is not a business that new competitors can enter easily. Anyone can buy a few airplanes, but try setting up a new network of railways! Not only is there little competition among US railroads, but these companies have also become very efficient. They have benefited mightily from terminating unprofitable routes during the period of industry consolidation. The train crews have been reduced from five workers to two, with a new push to cut that number to one.

The revival of the US railroad industry is fascinating to watch as it goes to show how a once written-off business can unexpectedly flourish again. Besides, it's a business steeped in history and romance (especially for those among you who owned their own miniature railway as a child). On top of all that, owning some of these shares (see below) could prove to be a lucrative (and safe) investment for years to come.

The four best shares in the sector

Two investment banks have upped their forecasts on CSX (NYSE:CSX, $63.67) in recent weeks, predicting healthy profits per share of $4.34. CSX is the largest railroad in the eastern US with 22,000 miles of tracks. It expects 12%-14% annual earnings growth over the next five years as more freight is pushed onto rails and is well worth investigating. America's number two operator, Burlington Northern Santa Fe (NYSE:BNI, $75.24) is particularly geared towards the coal sector. The company owns the largest network of rails in the red hot Powder River Basin in Wyoming, a remote area with huge reserves of low-sulphur coal. That spells out juicy freight rates for BNSF, which is sharply down on its 52-week high of $88 on 19 April, and looking attractive.

The biggest fish in the pond is Union Pacific (NYSE:UNP, $87.30) part of the original Dow Jones Transport Index. It operates 32,400 miles of tracks in 23 states, covering two-thirds of the US. With a 2007 consensus earnings estimate of $6.45 per share, the shares look cheap given the strength of the business model and growth prospects. Norfolk Southern Corporation (NYSE:NSC, $49.55) is a $20.9bn company that has doubled in value since 2004 and now trades at a 2007 p/e of 13. In fiscal year 2005, the company had a healthy pre-tax profit margin at 25%.

Recommended further reading:

See our section on investing in sectors for a variety of reports on different stockmarket sectors, including: Which broadcasters will survive the entertainment revolution; and How food companies are reacting to the junk food backlash.

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