RealMoney Silver - All Aboard the Guru Train

All Aboard the Guru Train
By John Reese
RealMoney.com Contributor
4/11/2007 2:00 PM EDT

The rail industry has been abuzz lately, first with the record-setting run of the V150, a 25,000-horsepower train that rocketed through northeast France at a world-record rail speed of 357.2 miles per hour, and then with the news that Warren Buffett's company had recently invested in three freight railroads.

The French train's performance got many in the rail industry, and even some U.S. politicians, talking about the potential future benefits of high-speed rail, while the news about Berkshire Hathaway's (BRKA) stock purchases got many investors thinking about the potential current benefits of investing in railroads.

After Buffett's rail interest was publicized, several freight lines enjoyed strong gains, led by Burlington Northern Santa Fe (BNI) , the only identified company among Berkshire's recent rail investments.

In a February column about companies that could benefit from higher ethanol demand, I highlighted Burlington Northern because ethanol is transported primarily by railroad, and because the company got strong interest from the strategy I base on the writings of renowned investor Peter Lynch. (Interestingly, the strategy that I base on Buffett's principles has little interest in Burlington Northern, or in any rail company for that matter. Burlington Northern's return on equity, return on total capital and expected return are all too low to pass my Buffett method.)

Amid the recent railroad hubbub, I decided to evaluate other companies in the industry by using my "guru strategies" -- computer models that each mimic the philosophy of a different Wall Street great. I found that several freight lines have posted strong growth numbers in the past few years, and largely because of that earnings growth, several besides Burlington Northern get strong interest from my Lynch-based strategy.

Before I get into which companies made the grade, I'd like to first note that railroads are historically a slow-growing industry, and I don't expect them to sustain the high earnings growth rates you'll see below. But nonetheless, these companies are in a strong financial position, and there are signs that it may be a good time to invest in the rail industry.

Genesee & Wyoming

One freight railroad that attracts strong interest from my Lynch-based strategy is Genesee & Wyoming (GWR) , which owns or has an interest in 49 railroads in the U.S., Canada, Mexico, Bolivia and Australia. The U.S. interests of the company, which has a market cap of $1.1 billion, are located in several regions, including Illinois, New York/Pennsylvania, Oregon and Utah.

To identify growth stocks that are still reasonably priced, Lynch famously uses the "P/E/Growth" ratio, which divides a stock's price-to-earnings ratio by its historic growth rate. My Lynch-based model considers P/E/G ratios of 0.5 or less to be the best case.

Genesee & Wyoming has a P/E ratio of 9.59, which, when divided by its historical 49.4% growth rate (based on the average of the three-, four- and five-year earnings-per-share figures), yields an excellent 0.19 P/E/G ratio. The strategy does caution that the high growth rate may not be sustainable in the future, but the strong P/E/G ratio indicates that Genesee has been performing well and is still a good buy.

Lynch also likes companies with little or no debt. With a debt-to-equity ratio of 47.23%, Genesee & Wyoming's debt is less than half of its equity and below my Lynch strategy's 80% maximum.

Norfolk Southern

Another freight rail company in which my Lynch strategy has strong interest is Norfolk Southern (NSC) , which operates more than 21,000 miles of routes in 22 states as well as the District of Columbia and Ontario, Canada. The company recently announced that it expects earnings to dip by about 3% in the first quarter, citing bad weather that slowed operations, declines in the automotive and housing sectors and lower-than-expected income from property sales.

But the rail operator, which has a market cap of $21.2 billion, has a history of good performance, with earnings increasing in each of the past five years. Its growth rate of 37.4% (based on the average of the three-, four- and five-year EPS figures) is again high for a railroad and tells a story of solid profit growth in this industry over the past few years.

The Virginia-based company has a P/E ratio of 14.27, which, when divided by the 37.4% growth rate, yields a strong 0.38 P/E/G ratio. That indicates that the stock is still selling at a good price, and any dips it may take because of its first-quarter numbers could create a nice buying opportunity.

Norfolk Southern's debt-to-equity ratio, at 68.64%, is also good enough to pass my Lynch-based method.

Tracking to the Great White North

Two more freight rail companies that my Lynch strategy likes have strong presences in both the U.S. and Canada. With a market cap of $22.6 billion, Canadian National Railway (CNI) operates more than 20,000 miles of routes, about two-thirds of which are in Canada. Its hubs range from Minneapolis to Buffalo to Baton Rouge.

Canadian National has a P/E ratio of 13.13 and a growth rate of 27.08% (again based on the three-, four- and five-year EPS growth rates). That makes for an impressive 0.48 P/E/G ratio.

For companies whose sales are more than $1 billion, my Lynch-based model looks for P/E ratios below 40, because large companies can have trouble maintaining a growth rate high enough to support a P/E greater than 40. With sales of $6.67 billion and a P/E ratio of 13.13, Canadian National passes this test.

Canadian National's debt-to-equity ratio of 57.04% also passes my Lynch-based standard.

Canadian Pacific Railway (CP) also has a strong presence in the U.S. and Canada. It owns or has a stake in close to 14,000 miles of track, about 9,000 of which is in Canada.

With moderate earnings growth of 16.89% and nearly $4 billion in of sales, Canadian Pacific is considered a "true stalwart" under my Lynch method. Lynch always keeps a few stalwarts in his portfolio, because they offer moderately good protection in a recession or hard times. When evaluating stalwarts, Lynch considers a stock's yield in determining the P/E/G. My Lynch strategy likes companies to have a yield-adjusted P/E/G of no more than 1.0, and Canadian Pacific's yield-adjusted P/E/G, 0.71, passes this test, showing that the stock is still selling at a good price.

Lynch also wants stalwarts to be profitable, so my Lynch-based model calls for such companies to have positive EPS in the current year. Canadian Pacific, which has a market cap of $8.6 million, is posting earnings of $4.33 per share this year, passing that test.

Railroads are typically slow-growing stocks. Just as I don't expect these companies' locomotives to challenge the V150's speed record anytime soon, I also don't expect them to keep posting growth rates in the 30% to 40% range. Nonetheless, all of the operators I've mentioned have track records of good performance and are not overloaded with debt.

When you combine that with the increased demand for freight rail generated by the need to transport commercial goods and non-oil fuels, these rail lines are all in good position to continue doing well, making each a stock you should consider adding to your portfolio.