Like Buffett, Rail Investors Could Be on the Right Track

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When you land on one of the railroads in a game of Monopoly, there's a good reason not to pass on buying it.

In his recently released 2016 letter to Berkshire Hathaway (BRK.A) (BRK.B) shareholders, Warren Buffett sings the praises of his company's ownership of Burlington Northern Santa Fe by describing the resilience of the railroad's operations. With respect to the company's debt, Buffett says that it has "earning power that, even under terrible economic conditions, would far exceed its interest requirements."

Railroads might not be very exciting businesses, but that's the very feature that piques Buffett's interest. In the letter, the investing legend summarizes his faith in the sector: "Our confidence is justified both by our past experience and by the knowledge that society will forever need huge investments in both transportation and energy."

Over nearly two centuries, railroad companies have been shipping stalwarts through market ups and downs. Keith Schoonmaker, Morningstar's director of industrials equity research says, "It's this constant presence that makes railroads an ideal holding for long-term investors."

That's not to say the sector hasn't faced some bumps and bruises. According to Morningstar, total rail traffic volume in 2015 and 2016 dropped by 2.3% and 5%, respectively, "due to falling energy and coal demand." Data collected by the Association of American Railroads (AAR) shows that U.S. rail coal tonnage has fallen from 850 million tons of coal in 2007 to 492 million in 2016, a decrease that Morningstar says has negatively affected stock prices.

The bigger historical picture, however, shows strong gains, with the Railroad sub-index of the S&P 500 climbing by more than 2,000% since January 1990 (compared to 566% for the entire index). AAR data also reflects that coal volumes have come back up by 16% year to date.

And perhaps with President Trump's directive this week to undo regulation affecting climate control and coal mining, there might be a slight increase in volume in the future.

Buffett argues that BNSF has been a leader in pursuing "planet-friendly technology" and uses only a single gallon of diesel fuel to move a "ton of freight almost 500 miles. Those economics," he argues, "make railroads four times as fuel-efficient as trucks. Furthermore, railroads alleviate highway congestion-and the taxpayer-funded maintenance expenditures that come with heavier traffic-in a major way."

Schoonmaker says that the Trump administration could help railroads immensely if it were to cut corporate taxes. "While other industrials might use the excess cash to buy back shares or raise dividends," he says, "the railroads are more likely to reinvest, and that could be a boon to stock prices."

Using stock screening models that I created using the investing philosophies of some of the most successful investors, I have identified the following high-scoring railroad operators and suppliers:

Canadian Pacific Railway (CP) owns and operates a transcontinental freight railway in Canada and the U.S. The company transports bulk commodities, merchandise freight, and intermodal traffic over a network of approximately 12,400 miles. My Peter Lynch-inspired screening model favors the ratio of price-earnings to earnings-per-share growth (PEG ratio), which indicates fairness of price. At 0.59, CP passes the requirement to be under 1.0. My Lynch model gives the stock a score of 72% (out of a possible 100%).

Canadian National Railway (CNI) is engaged in the rail and related transportation business through a network of approximately 20,000 route miles of track. The company scores well under our Validea Momentum investment strategy due to its quarter-over-quarter growth in EPS of 28.57%, well above the preferred level of 18%. This model also likes that the recent share price of $73.84 is within 15% of the 52-week high ($74.10). Modest leverage (debt-equity of 0.64) and return on-equity of 24.4% (compared to minimum requirement of 17%) add to the stock's attractiveness.

Greenbrier Companies (GBX) is a designer, manufacturer and marketer of railroad freight car and related equipment in North America and Europe and earns a perfect score under my Kenneth Fisher-based stock screen. The stock's price-sales ratio of 0.49 is well under the maximum level of 0.75 and indicative of exceptional value. Long-term, inflation-adjusted EPS growth of 57.80% is nearly four times the minimum requirement of 15% and average, three-year net profit margin of 6.44% exceeds the minimum requirement of 5%.

American Railcar Industries (ARII) is a designer and manufacturer of hopper and tank railcars and a high-scorer under my Benjamin Graham-inspired investment strategy due to its revenue base of $639.1 million (trailing 12-month sales) as well as its favorable liquidity (current ratio of 3.58). This model requires a P/E ratio of less than 15 and, at 10.63, ARII passes with flying colors. My Lynch-based investment strategy likes the company's PEG ratio which, at 0.39, is considered best case.

At the time of publication, John Reese and/or his private clients were long GBX and ARII.

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