Warren Buffett Really Likes Railroads; Should You?

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Four years ago Warren Buffett’s Berkshire Hathaway (NYSE:BRKA) purchased one of the largest rail transport companies in the world—Burlington Northern Santa Fe. Since then the shares of Burlington Northern’s competitors have continued to rise. Regardless of higher prices Mr. Buffett still believes that railroads make for compelling investments, as evidenced by comments he made recently on CNBC. Furthermore, the market seems to agree as shares of the major railroad companies are, for the most part, hitting all-time highs.

Here’s why these companies make for such compelling investments.

First, rail transport companies operate as a de facto oligopoly. There are only a handful of railroad companies that operate across North America, and in any given region west these companies usually only face one or two competitors. In some of the more remote regions in Canada and in parts of Mexico companies such as Canadian National (NYSE:CNI) and Kansas City Southern (NYSE:KSU) face no competition: If some company wants to ship goods by rail from parts of northwestern Canada, for instance, it must ship through Canadian National.

Furthermore, these companies have a very wide economic moat. It takes billions of dollars to build out a network of rail track as extensive as those networks owned by companies such as Norfolk Southern (NYSE:NSC) or Union Pacific (NYSE:UNP).

Second, railroad companies have a lot of pricing power. This comes in part from the fact that these companies operate as an oligopoly. While I am not accusing the rail transport industry of price-fixing these companies know that it is in their best interest to keep prices steady and within range of their competitors so as not to start a pricing war.

I should also point out that rail transport companies offer less expensive shipping solutions for companies shipping goods in bulk than their trucking counterparts. Trucks are extremely inefficient relative to trains. First, trucks are less fuel efficient relative to trains. In a world in which fuel prices are rising, this favors rail transport companies. Second, trucks require one driver each, whereas a train is akin to hundreds of trucks linked together. This means that train operators save money on labor. This is a big deal considering that labor costs go beyond simply paying employees. Employers also have to file paperwork with the government and pay payroll taxes.

Given these two points, it is no wonder that the rail transport business has performed so well over the past several years. These companies have consistently grown their sales and their earnings over the years. They also have very strong profit margins.

I should also point out that the rail transport companies are, for the most part, very shareholder friendly. They buy back their own shares on a regular basis, and yet they have a history of doing so prudently. Norfolk Southern is a good example. The company struggled in 2012 with lower coal shipments, and as a result the market sold off the company’s stock. The company responded by buying back shares more aggressively. The stock now trades at nearly twice the price of the low and earnings are back up again.

Clearly there is a lot to like about this industry. One risk to the rail transport stocks is the potential for a weak economy. Since businesses ship fewer goods during a recession, rail transport companies’ earnings suffer as well. Nevertheless there is a small chance that these companies will suffer losses.

Investors looking to invest in the rail transport industry should consider waiting for a pullback. Most of these stocks are trading at or near all-time highs. However, if you see a 10 percent correction or so in any of the names mentioned, I think you need to consider buying some shares for the long term.

Earlier, we wrote about a few simple principles that Buffett follows while looking for investment options. Here’s a recap:

1. Invest within your circle of competence

Investors think that they can outsmart the market by finding the next big thing. Whether it’s social media, 3-D printing, or rare earth metals, it is incredible how a few news stories and stock price increases can create an entire group of people devoted to a particular sector of the economy. But at the same time, these people probably don’t know much about these sectors. Do retail investors honestly know how a 3-D printer work, or how a computer chip works? Probably not. But that doesn’t stop them from buying 3D Systems (NYSE:DDD) or Intel (NASDAQ:INTC). While they may make money, they won’t do so because they understand their investments.

Buffett’s response to these investing frenzies is to invest in what you know. While you probably don’t know how a computer chip works or why Intel makes computer chips that people want to buy, you probably know, for instance, why Coca-Cola (NYSE:KO) is such a popular drink: It tastes good and the company has exceptional marketing. Thus, Coca-Cola falls within your circle of competence even if you don’t know the company’s secret formula. All you need to know is why the company is successful, and you can postulate with relative certainty that this success will continue into the future.

Investing in companies that make simple products that you understand may be boring, but it is a winning approach that can generate a lot of value over time.

2. Buy wonderful companies at a fair price

The full saying is that it is better to buy a wonderful company at a fair price than a fair company at a wonderful price. When you are investing, you find value not just by looking at the numbers but by looking at intangible features as well such as management. A company that is well managed and that has a reputation for providing a quality product is worth more than a company lacking these qualities. The former company is positioned to take market share from the latter, and it is better positioned to withstand economic weakness. As a result, from a long-term perspective, it is better to pay a higher price-to-earnings ratio for the shares of a high-quality company than to pay a low price-to-earnings ratio for a low-quality company.

3. Be greedy when others are fearful, and be fearful when others are greedy

Once you have decided which companies to buy using the first two pieces of advice, you need to know when to buy them. As with anything else you buy, you want to get a good price. However, the market fluctuates wildly and frequently, and this adds an emotional element to investing that this piece of advice helps you avoid. When stocks go down, people often assume it is for a reason (i.e., the downturn is justified). Similarly, when a stock rises, people often assume that it is because the company is improving. But market price fluctuations do not have any necessary correlation to a company’s fundamentals. As a result, you want to pick out companies to buy and then wait for the hit prices that you feel make them worthwhile investments.

This piece of advice depends on the first two mentioned. You cannot be confident in buying a falling stock, especially if it goes down even more after you’ve first bought it, unless you are confident in the company’s underlying business. For this to take place, you need to understand how and why the company makes money, how and why it will continue to make money, and what makes it such a great company. If you can figure this out, then you can have the confidence to buy when there is proverbial blood in the streets.

Disclosure: Ben Kramer-Miller is long CSX shares.

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