Barron’s analyst Jay Palmer believes the railroad industry is the place to invest:

a. The industry has got costs under control, margins are strong, and we has capital to invest; the next 20 years will be a golden age for rails.”

b. Stock prices reflect the good times. Over the past five years, the Dow Jones Railroad Index has shot up 250%, compared with a 30% gain in the S&P 500. The best performers did even better, with Burlington Northern stock rising 280% and Kansas City Southern and CSX each about 350%.

c. The long run-up has left freight rail stocks relatively expensive, changing hands about 19 times estimated earnings for this year; in the past the multiple averaged 13. Then again, the earnings outlook for most of the big seven is strong, with annual gains projected in the high teens.  BUT…….

d. The long-term environment is very positive

e. It’s easy to see what attracts Buffett to Burlington Northern. Like Union Pacific, it has tracks that crisscross the Western states, from the U.S. Pacific ports across to Kansas City and Chicago and down to Mexico and the Texas and Louisiana coasts. But while UP has lagged rivals in margins and free-cash generation, Burlington Northern has chugged along very nicely.

f. Higher volumes and improved pricing have helped generate record revenues in recent years. The company now plans to add intermodal capacity; to increase coal volume using fewer but longer trains; and to expand service to the agriculture sector.

g. Burlington Northern’s stock, as an example, after notching big gains earlier this year, has dropped back by 8% since early June, to about 105. That amounts to 17.7 times estimated earnings per share for this year, which looks reasonable in view of the nearly 20% earnings jump that analysts expect next year. The stock could easily climb another 10% within a year and then keep going.

h. Canadian National looks like another winner. Its roughly 20,000 miles of track spans Canada and mid-America, connecting three coasts: Halifax on the Atlantic, Prince Rupert on the Pacific and cities on the Gulf of Mexico. By purchasing several short-line rails, CNI has gained access to better serve the tantalizing Alberta oil sands region. Canadian National generates the highest profit margins of any North American railroad, plus a better-than-average 19% return on equity.

i. NOW, FOR THE FIRST TIME in decades, all the companies are delivering profits that can be used both to reward stockholders and, more important, pay for modern locomotives, rail cars, technology and new track. That’s a good thing, because new track is becoming absolutely crucial. Rail congestion is starting to develop and stands to get much worse.  The biggest bottleneck, and clearly the biggest potential crisis, is in Chicago, which handles about 40% of all U.S. rail freight on 180,000 trains a year and where lines from every one of the big railroads come together. A fix will not be easy: The tab could be as high as $4 billion over the next five years.

CONCLUSION: Assuming the industry can meet such challenges, rail transportation should continue to offer more and more people and businesses an alluring alternative to automobiles, trucks and airplanes. For investors, now may be just the time to buy a one-way ticket on the Fat City Express.

In addition to Burlington Northern and Canadian National, other tantalizing stocks include: Union Pacific, Kansas City Southern, CSX, Canadian Pacific, Norfolk Southern, Wabtec (vendor to industry), Bombardier, and China Railway Construction.

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