Train-to-truck and crude oil shipments are growing like gangbusters in the railroad industry, and to keep up, railroads are pouring billions into brand-new infrastructure. But those extra tracks, yards, and terminals don't come cheap. To achieve real growth, railroads need enough money to not only maintain what they have, but keep expanding. Thus, investors seeking winners in the railroad sector should look for companies with the highest returns on their capital investments.

How railroads are reinvesting their cash
BNSF Railway, owned by Berkshire Hathaway , is spending a record $4.3 billion to maintain and expand its network, up 19.4% from capital expenditures in 2012. The company is the leader in capital investments in 2013, compared to six other North American railroads. 

BNSF is spending $800 million on "expansion capital," according to spokesman Steven Forsberg. That amount includes more than $200 million to expand track and rail yard capacity through North Dakota and eastern Montana, where railroads have experienced a boom in shipping crude from the Bakken formation. 


BNSF is also spending $1.1 billion on locomotive, freight car and other equipment, much of which will serve North Dakota. In addition, the company is completing its Logistics Park Kansas City. Right now, its cranes there can lift 500,000 truck containers and trailers annually, but that number will grow to 1.5 million containers at full capacity.

Union Pacific  invested a record $3.7 billion in 2012, and it expects to invest another $3.6 billion this year in capital improvements. Union Pacific planned to complete a total of 1,500 projects across its 32,000-mile network this year to help improve train operating efficiency, reduce motorist wait times at crossings, and enhance safety.

Canadian National Railway expects to spend $2 billion on capital programs in 2013, up from $1.73 billion in 2012. CN is building an intermodal terminal in Joliet, Ill., and completing its Calgary Logistics Park. CN will spend $200 million in 2013 for the acquisition of locomotives, intermodal equipment and cars.

Last May, Canadian Pacific Railway  announced that it was increasing its 2013 capital budget 10% to $1.2 billion. The extra money came from a higher-than-anticipated cash-flow projection. The company upgraded track on the north main line between Winnipeg, Manitoba, and Edmonton, Alberta; and improved signaling systems on a mainline between Moose Jaw, Saskatchewan, and Chicago.

Measuring greatness
Railroads' return on invested capital is perhaps the best measure of whether managers are allocating their capital wisely. To calcuate this metric, divide a company's earnings by its total capital. Here are ROIC numbers for seven Class I Railroads:

Name 2011 Return On Invested Capital  2012  2013
Union Pacific  10.77  12.81  13.23
Canadian National  12.75  13.81  12.66
Canadian Pacific  12.03    9.93  14.35
BNSF Railway    8.49    9.36    8.28
CSX    8.41    8.24    8.33
Norfolk Southern     9.20     8.00    7.88
Kansas City Southern    5.54    6.93    5.69

Source: Morningstar, except BNSF Railway numbers, which are my calculations.

The top capitalists
The chart tells us that Union Pacific, Canadian National, and Canadian Pacific are really good managers of capital. Their most recent returns top 10%, which is outstanding for a capital-intensive business like railroads.
 
Canadian Pacific is really getting a big bang for the buck when it comes to investing in its business. Return on invested capital has improved to 14.25% from 9.93% in just the past year. Shareholders have to be pleased. Canadian Pacific shares are up 12% since earnings were announced Oct. 23, and up 43% year to date through Nov. 8.
 
The company's third-quarter earnings came in at $1.81 per share, up 39% year over year. The game changer for the quarter was the company's operating ratio falling to a record low of 65.9% -- an 820 basis point improvement over third-quarter 2012. Operating ratio is total expenses divided by total revenue.
 
Advice from an investment sage
As Warren Buffett's partner Charlie Munger said about returns on invested capital: 
Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return-even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with one hell of a result.
Railroads likely won't achieve 18% returns on invested capital, because they require so many maintenance costs over their vast networks.  But lower operating rations and higher revenues have helped top-performing railroads' returns on invested capital improve to more than 10%.
 
Track down these stocks
Investors are wise to own railroads in their stock portfolios. These railroads are highly sophisticated businesses with diverse franchises, vital to the U.S. economy, with a positive outlook for agriculture, automotive, crude-by-rail and intermodal traffic. The companies with the highest returns on invested capital should generate the highest stock appreciation -- and in this regard, Union Pacific, Canadian National and Canadian Pacific deserve kudos for their excellent management of capital investments.

The article Railroads Lay Track for Oil, Freight & Profit originally appeared on Fool.com.

Michael Hooper owns shares of Berkshire Hathaway, Union Pacific, Canadian National Railway, and Canadian Pacific Railway Limited (USA). The Motley Fool recommends Berkshire Hathaway and Canadian National Railway. The Motley Fool owns shares of 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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