Songs about the railroad often remind us of simpler times. On rainy days, I'll turn to jazz hits like "Take the A-Train" for comforting background music. Similarly, railroad companies can bring stability to one's portfolio in a dreary economy. Let's take a look at how this sector can provide steady returns and sweet music for investors' ears.

It's the pricing power
In the 1970s, the railroad industry faced an environment similar to the auto sector in 2008. The government stepped in to aid the struggling Penn Central Railroad much like how it bailed out Chrysler and General Motors a few years ago. Later, the government consolidated the still-struggling Penn Central with five other railroads.

 Today, four major carriers control 90% of the market for freight rail transportation. These carriers include CSX (NYS: CSX) , Norfolk Southern (NYS: NSC) ,Union Pacific (NYS: UNP) , and Burlington Northern Santa Fe, which is currently held by Berkshire Hathaway  (NYS: BRK.B) . With less than a handful of major railroads competing, they tend to match one another's pricing strategies over time. Not surprisingly, their share prices move in lockstep as well, significantly outperforming the S&P over the past decade.

Soaring stock prices and rising rates for rail transport have led some customers to cry "cartel." However, railroads counter by citing fierce competition with trucking and air cargo. Rail accounts for 42% of intercity freight in the U.S., but railroads shell out a lot of cash to ensure they keep running safely and smoothly. As a percent of total revenue, railroads spend four times as much as trucking companies on infrastructure and other capital expenditures.

Because of the competitive environment and capital-intensive nature of the rail business, regulatory bodies have gained little traction in repealing the favorable antitrust exemptions currently in place. In a 2008 study, a division of the Department of Transportation known as the Surface Transportation Board denounced the claim that railroads are exerting undue pricing power. The STB focused primarily on the return on invested capital earned by the industry, and concluded that railroads were not earning above-normal profits.

For now, major railroads are hoping the STB doesn't change its tune.

It's the economics
From my perspective, it's not the pricing power of the big four, but the economics of rail transport that account for recent gains in this sector.

The transportation sector typically follows the U.S. economic cycle -- the demand for transportation of goods rises and falls with demand for the goods themselves. However, railroads weathered the downturn surprisingly well due to several key factors. Most notably, rising fuel costs hit truckers and air cargo carriers much harder than railroads. Fuel costs eroded about 14% of rail revenue in 2010, but they absorbed 21% and 35% of revenues in trucking and air cargo, respectively.

A recent study showed that the tipping point for customers hovered around $70 per barrel of oil. Below this price, customers opted for trucking. Above this price, customers preferred rail. West Texas Intermediate crude has not dipped below $70 in over a year.

In addition to fuel prices, railroads benefit from consistent demand for commodities. The transportation of coal and grain accounted for 41% of overall rail revenue in 2009. Standard & Poor's Industry Survey noted that factors like "weather," "politics," and "currency value" drove demand for these goods, which were less susceptible to the broader economic cycle. Countries around the world rely on these products for electricity and food. As a result, demand for rail transport stays comparatively steady even when the U.S. economy veers off the tracks.

Either way, it's a sound investment decision
Railroads appear well-positioned to capture additional market share in the transport industry. Air cargo and trucking competitors will bear the brunt of inflated fuel prices, and according to Fool colleague Dan Dzombak's analysis, high oil prices are here to stay. Furthermore, competitors rely on fickle demand for consumer goods, but railroads will prosper from surging demand for commodities. Incorporating positive growth prospects, I believe shares in many rail companies are undervalued.

Company

P/E Ratio

1-Year Net Income Growth Rate

5-Year Net Income Growth Rate

Dividend Yield

Union Pacific

16.0

21.5%

17.0%

2.4%

CSX

13.0

25.0%

8.4%

2.3%

Norfolk Southern

14.3

31.2%

4.7%

2.4%

Kansas City Southern (NYS: KSU)

25.0

80.1%

31.5%

0.0%

Canadian National Railway (NYS: CNI)

15.3

8.5%

3.3%

1.6%

Canadian Pacific (NYS: CP)

20.7

(20.7)%

(7.4)%

1.9%

Source: S&P Capital IQ. Net income growth rate is annualized.

The six major North American railroads shown above combine for an average one-year growth rate of 24.3% and a price-to-earnings multiple of 17.4. Five of these railroads deliver dividend yields around 2%, providing a solid and steady, if not spectacular, payout for investors. Based on these metrics, I think investors can find bargains in this sector. CSX, for example, looks attractive given its relatively low P/E ratio. I personally own shares in this company and believe its growth story is likely to continue. CSX raised its dividend eight times in the past five years and reported record-setting earnings in the third quarter of 2011. As the largest player on the eastern seaboard, CSX benefits from the ability to connect America's coal-rich areas with key emerging markets.

Will the music ever stop for railroads?
In the past five years, mega-investors like Warren Buffett have begun to sing the praises of railroads. He described Berkshire Hathaway's acquisition of BNSF as "an all-in wager on the economic future of the United States." Not surprisingly, investors took note. This is a sector that's been around for 180 years and continues to grow. In my opinion, railroad stocks have yet to top the charts.

Want more dividends?
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At the time this article was published Fool contributor Isaac Pino owns shares of CSX. Follow him on Twitter @TMFBoomer. The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Canadian National Railway and Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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