Railroad Investing Is Suddenly Fashionable and Profitable

Imagine it. Chinese engineers laid 1110 kilometres of track from Golmud, in the Qinghai Province, to Lhasa, the capital of Tibet. They did it in less than four years. In typical Chinese fashion, that was three years ahead of schedule. About 38,000 workers advanced more than half a mile a day. At times, they had to tunnel through ice and rock with temperatures as low as 31 degrees below zero.

Swiss engineers, who have some expertise in matters of tunneling through mountains, thought no one could get through the Kunlun mountain range. The peaks of Kunlun wear snow hats year-round. Passes weaving through the range still climb more than 15,000 feet. Oxygen is at a premium up there. Then there is the steepness of the grades the trains must climb. They are steeper than any railroad anywhere in the world.

Yet the Chinese have their railroad, and more are on the way. China has more than 51,500 kilometres of track. The Chinese ambitiously add to that total every day. Demand for rail service is high. During peak season, China's rails carry more than 5.2 million passengers a day.

In the last week of May, China introduced its first bullet trains - 280 cars capable of travelling up to 250 kilometres per hour. Now you can get from Beijing to Shanghai in 10 hours, instead of 12. Tickets sold out quickly.

China's railroad revival is not unique to China. All around the world, it's becoming clear: The rails are back.

In the US, several savvy market personalities have taken a sudden interest in railroad investing. Warren Buffett recently bought stakes in three freight railroad investments: Burlington Northern Santa Fe Corp. (NYSE: BNI), Union Pacific Corp. (NYSE: UNP) and Norfolk Southern Corp. (NYSE: NSC). He was not alone.

Billionaire and fellow investing legend Carl Icahn also picked up some railroad shares. He bought a US$122 million stake in CSX Corp. (NYSE: CSX). King Carl's interest in the railroad story runs deep. He is also chairman of American Railcar Industries Inc. (NASDAQ: ARII), a manufacturer of railroad tank cars.

What's especially interesting is that these old warhorses - famous bargain hunters, both - took their positions as these railroad stocks were making new highs. The Standard & Poor's 500 railroad investing index has more than doubled since the end of 2002. It's up another 23% in 2007 as I write.

As The Economist recently noted: "It's been a long time since railways have become so fashionable". The ever-sober magazine recounts bits of the railroad industry's sad history. Railroads were once the dominant choice for intercity traffic, with 75% of the market in as late as 1929. By 1980, that share fell to 38%, as new roads and trucks ate into their share of the pie. About a third of railroads lost money. Deregulation, begun that year, set off a 20-year period of restructuring and consolidation. Only seven of 31 Class I railways survived this lengthy and brutal bear market.

But those surviving railroads are making big profits. "Strong demand for coal, agricultural and container services - the 'holy trinity' of freight - has trains running at full steam," says The Economist. The railroads gush cash, some of which they pay out in higher dividends and to buy back stock. The rail renaissance is on and with it, railroad investing.

Some of this story links to China, as these things always seem to these days. Railroad companies are busy laying track and building terminals to accommodate tens of thousands of containers coming into this country every day - many from China. We are in the midst of a great cargo boom, the effect of which also extends to the rails. More and more of that freight gets loaded on railcars, as opposed to a truck trailer.

Trucking costs are high. Truckers struggle with the high prices of gasoline and diesel - trends not likely to reverse anytime soon. High oil costs hit trucking much harder than they hit railroads, which are three times more oil efficient, as Buffett has pointed out. Trucking companies have difficulty finding long-haul drivers and face high insurance premiums. Increasing gridlock in most cities makes delivery a little less reliable.

Another reason for the rail revival: the rise of cities. We are at a tipping point in world history: By the end of this year, more people will live in cities than not. Many of these cities suffer the same problems: congested roads and lack of urban land.

Therefore, there is a growing premium on urban space. Cities and developers must look at better ways to use existing space. Increased reliance on rail helps this effort. Rail delivers large numbers of people and freight without taking up much precious urban land, as compared with accommodating increased car or truck traffic - or even building an airport.

The rails also help stave off gridlock on the overcrowded roads of the world's cities. More traffic by rail may absorb people and freight that otherwise would have gone by car or truck.

The rails appease the green crowd, too. Air travel is a big polluter. Flying results in twice as much air pollution as traveling by rail. Airlines also struggle with the high cost of fuel.

All of these reasons factor into the recent popularity with railroad investing. You could go out and buy any of the railroads yourself and gain exposure to this trend. Take a ride along with Buffett and Icahn and other savvy investors who are also buying railroads.

There is always a crisis somewhere at some stage of development - some just beginning, some in bloom and some just ending. In the case of the railroads, it looks like their long stretch of troubles is over. The rails are back.

Regards,

Chris Mayer
for The Daily Reckoning Australia

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