Here's a concept you don't hear every day: If you missed the boat on energy stocks, consider taking the trains.

If the bull market is going to continue, then the transportation stocks are going to head to new highs. In this economy, the railroads' prior investment in infrastructure, technology and capacity are now generating solid free cash flow. Managements are using this excess cash to boost share prices through buybacks.

The railroad stocks may complement the energy stocks in your portfolio. As of last Friday, the Dow Jones Transportation exchange-traded fund (IYT) was up 12.9% year to date, besting the S&P 500 ETF's (SPY) 12.2% performance. The S&P Energy ETF (XLE) is up 12.8% year to date. It seems like this year, the transportation stocks are finally getting the recognition for their well-positioned economic role and pricing power, which allows them to pass fuel-cost increases on to their customers.

In response to these favorable conditions, we give you the Ratings' three best large-cap buys from the Dow Jones Transportation ETF, which tracks the DJ Transport Average.

Our stock ratings model has been pointing over the last month to such an increase in the transportation stocks. What's driving the interest in large-cap Dow Jones Transportation stocks now?

A strong economic environment helps; it's natural to expect better stock prices and ratings on large-cap industrials that benefit from stable interest rates, low inflation, solid business growth and the ability to pass on costs.

Above-average earnings results also draw attention to this sector. It's surprising how many railroad companies have voiced this scenario as they have reported earnings over the last two weeks. For full-year 2006, it will be rare to find a publicly owned railroad stock that is not posting record earnings. Strong unit demand for shipping, technology integrations and the cumulative years of rail-system changes are clearly driving operating expenses lower and profits higher.

To make our list of outperforming transportation stocks, the stock has to score in the top 15th percentile in cash flow, total return to shareholders, capital efficiency, low-price volatility and solvency -- the five core factors in our stock-ratings model. The minimum market cap considered for this ranking was $10 billion, which filters out smaller, more volatile stocks.

For the purposes of this screen, the minimum rating acceptable at the time we run the screen is B+. (This is on a scale where A+ is a strong buy and E- is a strong sell. The B+ rating means that the company has a good track record of managing risks and the stock has proven to be a good investment in the recent past.)

Here, then, in reverse order of their overall rating and price performance, are the three transportation stocks that fit this profile and meet our investment criteria.

The third pick on the list is

Burlington Northern Santa Fe


, up 11.1% year to date. In the third quarter, this $27.4 billion market cap railroad posted earnings per share of $1.22, up 33% over the prior year. BNI also reported solid volume growth, up 7.4%, which it attributes to broad demand for coal shipments and West Coast container traffic.

Our model gives this stock high marks for top-line growth and relatively low-price volatility, but low marks for capital efficiency. With estimated free cash flow of more than $700 million, BNI management is looking to add to capacity with an anticipated $2.6 billion in capital spending for the year. With leading top-line growth numbers, an active share repurchase program and a solid capital position, this stock should not be lagging its peers' stock performance for long.

The second on this list is the largest railroad in North America,

Union Pacific Corp.

(UNP) - Get Report

. This $24.2 billion market cap stock is up 14% year to date and posted EPS of $1.54 in the third quarter, up 64% on an adjusted basis over the same quarter last year. Top-line revenue growth came in at 15%, but overall volume came in at a more modest 3% increase.

On a customer-segment basis, UNP saw its best growth from agricultural products shipments, up 19% year over year. Its slowest growth came from auto-part shipments, up 10% year over year. The lower growth for auto-part shipments is not surprising, but still compares favorably against the recent results of other rail operators. On the capital front, management estimates it will generate $450 million of free cash flow this year.

Our model gives this stock high marks for top-line growth and very strong solvency levels. Given UNP's high operating expense margins, it's not surprising to see our model penalize this company for performing at return-on-equity levels that are half of the

S&P 500's

ROE. The upside in this stock is on the inside. If UNP management can reinvest/divest wisely to improve volume-generating capacity and lower its overall expense ratios, this could be a real boom for both customers and shareholders.

And the top pick is


(CSX) - Get Report

, up 44.6% year to date on solid earnings and a more solid share-repurchase program. While valuation measures are still 10% to 15% below peer averages, our model definitely prefers a stock with an uptrend, and this one has certainly demonstrated the value of a positive stock-price slope.

Operations are producing record results. Two weeks ago, the company reported a 50% increase in comparable third-quarter earnings, excluding hurricane-related items and tax benefits.

To get a clearer picture, focus on the activity drivers. Given a lackluster 2% volume growth, the 14% increase in revenue appears to be due to higher pricing power. As CSX management stated in its conference call, "The renaissance in the industry continues as merchandise, coal and intermodal traffic grows and the operating environment remains strong."

Financial flexibility continues to improve. Free cash flow is growing by $300 million a year and the company is halfway through a $500 million share-buyback program. With another $228 million left on its share buyback authorization and free cash flow of $300 million, expect opportunistic capital management to continue.

Workin' on the Railroad
Our top picks are doing well against the averages.

Click here for larger image.

Source: Ratings

Over the past quarter, our stock rating model has been gradually adding transportation stocks, especially railroads, to our list of recommended stocks. But be careful: Before proceeding to invest in the names on the list, note that just filtering stocks on a set of financial or technical criteria alone can expose your portfolio to risk. Also remember that past performance is not a guarantee of future gains, especially for a nondiversified list of fast-track railroad stocks.

For more ratings on stocks, you can search for individual stocks



Rudy Martin is the director of research for Ratings. In keeping with TSC's Investment Policy, employees of Ratings with access to pre-publication ratings data must pre-clear any potential trade through the legal department, and are prohibited from trading any security that is the subject of an unpublished rating revision until the second business day after the rating is published.

In keeping with TSC?s Investment Policy, employees of Ratings with access to pre-publication ratings data must pre-clear any potential trade through the legal department, and are prohibited from trading any security that is the subject of an unpublished rating revision until the second business day after the rating is published.

While Martin cannot provide investment advice or recommendations, he appreciates your feedback;

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