(The following column by John Reese appeared at Forbes.com on September 7. John P. Reese is founder and CEO of Validea.com and Validea Capital Management. He is also co-author of The Market Gurus: Stock Investing Strategies At the time of publication, John Reese and his clients had no positions in any stocks mentioned in this article.)
NEW YORK — As the market has headed downward over the past month or two, there’s been speculation that the climate might be right for the great Warren Buffett to go on a bit of a buying spree.
After all, Buffett said earlier this year that his company Berkshire Hathaway is looking to make a $40 billion to $60 billion investment sometime soon, and the recent price drops could signal a chance for the investing world’s greatest bargain-hunter to spring into action.
Buffett has been mum on whether he has something huge in the works, but one move Berkshire has made recently involved upping its stake in rail operator Burlington Northern Santa Fe. Berkshire bought 845,000 shares of the railroad last week, meaning it now owns about 15% of Burlington. And that’s not the only railroad operator that Buffett has been bullish on. Earlier this year, Berkshire disclosed that it also has sizable investments in both Union Pacific and Norfolk Southern.
Like Buffett, my “guru strategies”– computer models that mimic the investment philosophies of different Wall Street greats–are also high on railroads. But interestingly, it’s not my Buffett-based strategy that rates them highly, but instead the model I base on the writings of Peter Lynch. Here’s a look at Burlington and a few other freight railroad stocks, and why my Lynch-based strategy is keen on them.
Burlington Northern Santa Fe: Through its subsidiary, BNSF Railway Company, Burlington Northern operates about 32,000 miles worth of routes in 28 states and two Canadian provinces. The Texas-based railway is one of the world’s top transporters of intermodal traffic, moves more grain than any other American railroad and hauls enough low-sulfur coal to generate about 10% of the electricity produced in the U.S. Burlington Northern has a market cap of $29.3 billion.
With a 27.6% growth rate (based on the average of its three-, four- and five-year earnings-per-share figures), Burlington is one of several railroads considered a “fast-grower” by my Lynch-based model–Lynch’s favorite type of investment. While that kind of growth demonstrates just how much the rail industry has taken off recently, I wouldn’t count on companies in this traditionally slow-growing field to keep posting growth in the 25% to 40% range. Nonetheless, there are signs that rail stocks are ripe for more growth. Forbes’ Andrew Farrell notes, for example, that railroads are benefiting from an increase in traffic as American consumers use more foreign goods, overseas demand for U.S. commodities rises and trucking companies are hampered by high fuel costs.
My Lynch-based method indicates that Burlington does still have room to grow. To identify growth stocks that are still selling at a good price, Lynch uses the price-to-earnings-growth ratio, which divides a stock’s price-to-earnings ratio by its growth rate. P/E/G ratios below 1.0 are acceptable, with those under 0.5 the best case. With a P/E ratio of 16.88 and that 27.6% growth rate, Burlington Northern sports a 0.61 P/E/G, passing my Lynch-based model’s most important test. (Note that even if that growth rate dropped by 10 percentage points, to a moderate 17.6% rate, its P/E/G would still be acceptable.)
Lynch also doesn’t like companies with a lot of debt, and the model I base on his writings requires companies to have debt/equity ratios no higher than 80%. At 74.68%, Burlington Northern’s debt/equity ratio isn’t great, but it is good enough to pass this test.
Norfolk Southern Corp.: Based in Norfolk, Va., Norfolk Southern operates more than 21,000 miles of routes in 22 states in the eastern U.S., as well as the District of Columbia and Ontario, Canada. The company is North America’s largest rail carrier of automotive parts and finished vehicles, and has a market cap of $20.3 billion.
Norfolk Southern is another rail company that has posted a very high growth rate recently (37.4%, based on the average of the three-, four- and five-year EPS figures). Its P/E ratio, however, is just 14.1. Those two figures make for a stellar 0.38 P/E/G, falling into my Lynch-based model’s best-case category and indicating that the stock is a good buy at its current price.
Like Burlington, Norfolk Southern is also not overburdened by debt. Its debt/equity ratio is 62.2%, good enough to pass my Lynch-based model’s test.
Canadian National Railway (nyse: CNI): Canadian National operates more than 20,000 miles of rail routes, about two-thirds of which are in Canada with the other third spread over 16 U.S. states. It is based in Montreal and its rail network is Canada’s largest, but its hubs also span much of the U.S., ranging from Minneapolis to Buffalo to Baton Rouge. Its market cap is $26.7 billion.
With a growth rate of 27% (again based on the average of the three-, four- and five-year EPS figures) and a P/E ratio of 15.86, Canadian National has a 0.59 P/E/G ratio, which easily comes in under my Lynch-based method’s 1.0 limit. Its debt/equity ratio, 56.78%, is also good enough to gain approval from this methodology.
Canadian Pacific Railway: Canadian Pacific also has a strong presence in both the U.S. and Canada. It owns or has a stake in close to 14,000 miles worth of track, about 9,000 of which is in Canada, with the rest in the midwestern and northeastern U.S. The Calgary-based company has a market cap of $10.7 billion.
On September 5, Canadian Pacific reached a deal to buy Dakota, Minnesota & Eastern Railroad Corp. for $1.48 billion. The move increases its network by another 2,500 miles and could help it expand into the coal-rich Powder River Basin area, where Union Pacific and BNSF currently carry a combined 450 million tons of coal per year, the Associated Press reported.
Unlike the other rail companies I’ve discussed, Canadian Pacific is a “stalwart” according to my Lynch-based method because of its moderate 17% growth rate and high ($4.44 billion) annual sales. For stalwarts, Lynch still uses the P/E/G ratio, though he adjusts for yield. Canadian Pacific’s yield-adjusted P/E/G is 0.92, good enough to come in under this model’s 1.0 upper limit.
In addition, my Lynch model requires stalwarts to have a positive current EPS; at $4.20, Canadian Pacific passes the test.
Another reason my Lynch-based method likes Canadian Pacific: Its debt/equity ratio (61.8%) comes in under the model’s 80% maximum.
Railroads are sometimes thought of as a relic of America’s past. But with higher fuel prices for trucking companies, increased demand for coal transport, and the need for a way to move an increasing amount of imported merchandise across the country, it appears they may end up being a major part of our economy’s future, too.
The four firms I’ve highlighted are well positioned to take advantage of the industry’s recent growth. If you’re looking to do the same, you’d be wise to consider adding any of them to your portfolio.