Why Warren Buffett is buying a train set

When Warren Buffett shelled out $4.4bn on US rail companies last year, many wondered why he had suddenly fallen in love with the sector. We have the answer - plus two of the best rail investments around.

You would normally associate Warren Buffett with big consumer brands like Coca-Cola and American Express. So when he shelled out $4.4bn on three US rail companies last week, many wondered why he had suddenly fallen in love with the sector. The simple answer is globalisation. With booming demand for commodities from the East and a hunger for cheap foreign goods in the West, the rail companies linking consumer and producer look appealing for the long haul.

The dominant trend is the demand for raw materials and machinery to fuel the construction booms in China and India. US rail firms transport grains and building and construction products for export; US exports to China rose by 32% last year. Railways are a Canadian story too. Just as ships carrying cheap Chinese goods are docking at ports on Canada's west coast, trains are arriving to meet them with CAD75bn worth of copper, lumber and oil to be shipped back across the Pacific. As Christopher Hancock notes in a Penny Sleuth newsletter, it takes about 30 years for an agrarian society to industrialise and China is only about one-third of the way there. So both countries' demand for Canada's natural resources will play into the hands of the freight firms for years to come.

Buffett will also have noted how the US and Canada have embraced alternative energy, with an increasing amount of coal being hauled across the country for energy production. Coal transport has been a significant factor in the 25% growth in transport volumes in the US since 2002. Potential competition from trucking companies is falling by the wayside amid rising fuel prices: railroads are able to transport the same amount of goods using just a third of the energy.

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Meanwhile, consolidation has all but eliminated competition in the rail sector. After falling on hard times in the 1970s, rail companies took advantage of the industry's deregulation in 1980 to streamline their tracks, labour forces and costs. Twenty-five years ago, there were 22 carriers in the US and Canada, now there are just seven. And new entrants are hardly likely to enter the industry, given the cost of setting up a new rail network. As Jim Jubak puts it on MSN Money, "the neatest thing about railroads is that nobody is making any more of them".

An important sign of the improved environment for railroads is that three of the top seven North American operators have now boosted their returns on investment to above their cost of capital, with another two expected

to hit this milestone soon. So investment in growth should become far easier. "That's a monumental achievement," Merrill Lynch's Ken Hoexter told the FT: "railroads have not achieved that return for almost 90 years as a group".

It's an encouraging overall picture: consolidation; quasi-monopoly status with huge barriers to entry; benefits from Asian and global trade; and a much-improved operational performance compared to capital outlays. While North American railways should profit from the commodities boom, the US slowdown has recently lowered freight volumes. But the industry looks capable of offsetting volume loss with improved productivity, according to Bear Stearns, and it's certainly optimistic about the long-term picture: its capital spending hit a record last year. Below are some railway stocks to consider.

The best stocks in the railway sector

Warren Buffett invested $1.4bn in Burlington Northern Sante Fe and speculation on the other two (as yet unnamed) companies has seen prices jump in the last week. But Norfolk Southern Corporation (NYSE:NSC), one of three firms from which Buffett must have picked his other two investments, remains a reasonably priced play on the transportation of coal, with a 2008 p/e of 12.4. Bear Stearns deems it "historically the best-managed" and most profitable railroad in its area.

A Canadian play on emerging market demand for raw materials is Canadian Pacific Railway (TSX: CP), which owns about 9,100 miles of track, stretching from British Columbia to Montreal. Robert Fay of Cannacord Adams says the shares, on a forward p/e of 14, are a buy.

A cheaper option is Canadian National (TSX:CNR), which is building a new $300m terminal in Canada to reduce its exposure to the US economy. The company is currently embroiled in a labour dispute, but this shouldn't distract investors from the group's "very strong" medium- to long-term potential, according to UBS's Fadi Chamoun. The stock, his top pick in the sector, is on a 2008 p/e of 12.7, and his target price is over a fifth above the current price.

Eoin came to Money Week in 2006 having graduated with a MLitt in economics from Trinity College, Dublin. He taught economic history for two years at Trinity, while researching a thesis on how herd behaviour destroys financial markets.

Eoin acts as managing editor of MoneyWeek's newsletters.