Warren Buffett and Bill Gates like Railroads, and you should too
Stoke the boiler on railroad stocks now
Shares of CSX Corp. CSX, -2.17% , Union Pacific UNP, -1.25% and Norfolk Southern NSC, -1.64% are each down between 20% and 25% since January. North of the border, shares of Canadian National Railway CNI, -1.62% and Canadian Pacific Railway CP, -0.37% haven’t fared much better.
But decent dividends, bargain valuations after the selloff, and the hope of a continued recovery for the U.S. economy may hint at a buying opportunity for long-term investors looking to take a position in rail stocks now. If so, you’d be on board with Warren Buffett, whose Berkshire Hathaway BRK.A, -1.00% BRK.B, -1.33% purchased Burlington Northern Santa Fe in 2009, and Microsoft MSFT, -1.59% founder Bill Gates, who is a major Canadian National shareholder.
Some of the pessimism in railroads is justified, of course. The beatings that commodity companies have been taking lately — particularly in coal and oil companies — have resulted in weaker rail traffic across key segments. As a result, through the first 35 weeks of this year, U.S. railroads have seen cumulative volume that is down more than 4% from the same point in 2014.
But much of the negativity is now priced in. Furthermore, as we enter the fourth quarter, the comps will start to look less miserable as year-over-year comparisons take into account the crash in energy and materials prices beginning in late 2014.
Here’s why railroad stocks may be a good investment now:
1. Intermodal upswing: For the week of Sept. 5, total rail traffic was actually up 8% year-over-year thanks to a 17% surge in intermodal traffic. That’s a good sign, even if details continue to show weakness in coal and oil. In fact, intermodal traffic — transporting marine shipping containers or truck trailers on railroad flatbeds — has been up year-over-year for over 10 weeks now, allowing railroads to fight through some of the weakness in commodity shipping.
2. Cost-cutting paying off: While the overall outlook for rail traffic isn’t so hot in the near term, these companies have been very proactive with cost containment. For example, CSX, which reported total expenses of $2.05 billion in the second quarter, down about 9% from $2.25 in the same quarter a year ago. Union Pacific saw a similar trend, with total operating expenses of $3.48 billion from $3.82 billion a year ago for a 9% decline. That will undoubtedly help support these stocks and boost profits going forward.
3. Easier comps in late 2015: Investors looking to front-run improvement in earnings should consider the final months of 2015 as a great opportunity, given the fact that energy prices began imploding roughly a year ago. After all, crude oil was at over $90 in September 2014 and is now half that level. Year-over-year comparisons in the third quarter may be bleak again for oil and coal carloads, but the precipitous fall of energy prices over the last 12 months will start to provide easier comps going forward for the railroad industry.
4. Bargain valuations: CSX and Norfolk Southern, for example, both trade for about 13 times forward earnings, while Union Pacific shares are priced at about 14 times its fiscal 2016 numbers. Considering a forward P/E of about 16.4 for the broader market, that’s a pretty attractive discount.
5. Decent dividends: Yields of between 2.4% and 2.9% for Union Pacific, CSX and Norfolk Southern aren’t the biggest paydays. But these companies have been paying dividends for decades — with 93 years of dividends from CSX being the “worst” of the group. Furthermore, payout ratios are clearly sustainable, with all three of these players paying a little more than a third of projected fiscal 2016 profits in dividends. That also means dividend growth is highly likely going forward.
6. Analysts are bullish: Wall Street price targets suggest that analysts think the worst is over for railroads. CSX has an average price target of about $35, roughly 20% upside from here, with Stifel Nicolaus actually upgrading the stock from “hold” to “buy” less than a month ago. NSC has been upgraded even more recently, with Bank of America Merrill Lynch putting a “buy” recommendation on the stock just last week, with about 12% upside based on the average price. UNP doesn’t have any recent upgrades, but does have roughly 20% to run from its current price to its median price target of $107 a share.
7. Hopes for a cyclical recovery: The continued strength of the intermodal segment is a specific reason to like railroads. For instance, motor vehicle shipping via rail has been strong in 2015 as the auto industry is pacing its best year since 2003. Data points like this also paint a general picture of a cyclical recovery in the U.S. where consumers and businesses spend more. This kind of environment is bullish for railroads — and, in fact, many point to rails as the leading indicator of any uptick in broader activity. If you wait for the “all clear” on consumer and business spending, railroad volume will already be on the upswing and the gains will be reflected in shares — so now is the time to buy and capitalize on this trend, while prices are still attractive.
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