The next selection for the Inflation-Protected Income Growth Portfolio is a two-for-one deal, half-positions in railroads CSX and Union Pacific . CSX has a strong presence that covers much of the eastern part of the United States, while Union Pacific covers the western part very well. Between the two of them, haulage is covered from the Atlantic to the Pacific with many, many points in between.

Both railroads have decent valuations, balance sheets, and dividend histories, yet only moderate overlap in their route networks. Buying both effectively gets a system that operates coast to coast, while only buying half-positions in each respects the diversification principle that protects the overall portfolio from an industrywide failure.

Why they're worth owning in the iPIG Portfolio
To earn a spot in the portfolio, a company has to pass a series of tests related to its dividends, its balance sheet and valuation, and how it fits from a portfolio diversification perspective.


Dividends:

  • Payment: Union Pacific's dividend currently sits at $2.76 a share, a yield of about 2.1%; CSX's dividend is at $0.56 a share, for a yield around 2.7%, both based on Monday's closing prices.
  • Growth history: Union Pacific has been paying higher dividends every year since resuming its increases in 2007, while CSX resumed increasing its dividends in 2005.
  • Reason to believe the growth can continue: Union Pacific pays out a mere 30% of its income as dividends, while CSX's payout ratio is even a touch smaller, at 29%. With such low payout ratios and earnings that are well supported by cold, hard cash, both railroads retain significant funds to invest for their future growth and have flexibility in a slowdown, as well.

Balance sheet and valuation:

  • Balance sheet: Union Pacific carries a debt-to-equity ratio of 0.5, while CSX's clocks in at 1.0. Those levels indicate that while both companies do use debt, they haven't overleveraged themselves to the point where a near-term financial hiccup would derail them.

Valuation: Both companies easily pass a valuation test pioneered by none other than Benjamin Graham, the founder of Value Investing. That said, Graham's equation does take interest rates into account, and today's low rates make stock values seem cheaper than they would be in a more normal rate environment. Still, even dialing rates back up to more "normal" levels, both would still look decently priced.

Diversification fit:
The previous picks for the portfolio included:

Like fellow iPIG portfolio pick shipping company UPS, these railroads are in the business of moving stuff around, which means they're not perfect from a diversification perspective. Still, they're different enough, given that railroads own their own infrastructure and generally focus on products that don't need to move quickly, unlike the express shipping common with UPS.

For diversification's sake, to keep the shipping part of the portfolio to a manageable level, the combination of the two railroads will be the same size as one other typical investment in the portfolio. It's all part of the balancing act needed to manage across risks in investing.

What are the risks?
And speaking of those risks, coal is an incredibly important commodity to the railroads. Yet, coal is seeing its once-dominant position in power generation attacked by cheap natural gas. That's one of the reasons why CSX was chosen instead of fellow Eastern U.S. railroad Norfolk Southern . While Norfolk Southern also looks very reasonably priced, it's in some ways more dependent on coal than CSX. Thanks to fracking, natural gas will likely remain cheap for a while, keeping demand for coal (and its transport by rail) down.

Of course, to really limit the impact from coal but still pick a railroad for the portfolio, Kansas City Southern would have looked like a reasonable choice, given that it has less exposure to coal than most of its peers. Still, Kansas City Southern's loftier valuation (due to that lower exposure to coal) & smaller dividend yield makes it a tougher stock to pick for a portfolio focused on dividends and valuation.

What comes next?
When the Fool's disclosure policy allows, I plan to buy both CSX's and Union Pacific's stocks for the Inflation-Protected Income Growth portfolio, as long as CSX's share price remains below $22 and Union Pacific's stays below $135. I expect to invest a total of around $1,500 approximately evenly across the two stocks, giving the combined position a 5% allocation in the portfolio, with 35% of the portfolio still remaining cash. Watch my article feed for details of the next pick, coming soon.

Also, to score the performance of this pick, I'm making an outperform CAPScall on both stocks at Motley Fool CAPS, putting my All-Star ranking on the line along with the plan to invest cold, hard cash.

Looking for stocks to add to your portfolio?
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The article Why These Railroad Stocks Are Worth Owning originally appeared on Fool.com.

Chuck Saletta owns shares of United Parcel Service. The Motley Fool recommends United Parcel Service. 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.

Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.


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