Published: August 27, 2009

It's no wonder Warren Buffett loves railroads so much -- they're a simple, easy to understand business. In fact, his investment vehicle Berkshire Hathaway (NYSE: BRK-B) has a stake in three of them.

This is exactly what Buffett was talking about when he said diversification is for people that don't know what they're doing.

Railroads have about as wide an economic moat as you can find. Aside from regulatory hurdles, the cost of building and maintaining railroads is enough to keep new competitors away. That makes existing tracks and railroad right-of-ways as good as gold.

Competition among the existing rail carriers is less intense than many suspect. Individual coal mines, agricultural facilities and chemical plants tend to only do business with a single railroad.

There are only four major railroads in the U.S. They carry several different types of freight and commodities ranging from consumer goods, automobiles, coal, agricultural products and chemicals.

The U.S. market has basically two duopolies: Two of the railroads dominate the West and Midwest, while the other two control the eastern half of the country.

The rail carriers have a leg up against the air freight and trucking firms. Many freight routes that were driven entirely by trucks now rely on "intermodal" traffic. "Intermodal" means that more than one type of transportation is used. This type of shipping has quadrupled during the past 25 years.

One reason for this increase is one rail car can move a ton of freight for more than 423 miles on a single gallon on diesel fuel. That puts railroads at a considerable advantage over trucks or airplanes. As roads become more and more congested in the U.S., this trend will play right into the rail carriers' hands.

All of these factors make the railroad business about as close to a legal monopoly as you can get.

Like most economically cyclical groups, earnings for the major railroads were hit by weak conditions as the economy slowed in 2008. The industry has taken steps to shore up profitability by furloughing workers, idling railcars and eliminating unprofitable routes as a result. But they are holding up well considering the collapse from historic highs in volume of goods transported.

All four of the major railroads agree the worst of the recession is over, but that economic conditions are less than ideal. Data published by the Association of American Railroads (AAR) indicates that rail volume trends are already improving early in the third quarter.

Railroads are sitting at attractive valuations in the meantime:

Buffett owns Union Pacific, Norfolk Southern and Burlington Northern. His largest position is Burlington Northern -- worth about $6.2 billion and making up more than 10% of Berkshire's portfolio. The value for Union Pacific and Norfolk Southern is considerably less.

While Burlington Northern seems to be Buffett's favorite railroad, the outlook for the entire industry will look promising when a recovery takes hold. Cyclical stocks often trade at high P/E ratios near the bottom of economic cycles because of depressed earnings conditions. In that light, these low valuations look even more attractive.


-- Nathan Slaughter
Editor
Half-Priced Stocks