Freight railroads and their investors can feel confident no new railroads will try to create a competing network — the cost is too high. So the six major players in the industry will continue helping businesses connect with suppliers and customers for years to come.
That enduring competitive advantage, combined with strong demand from shippers, is part of why Buffett's company, Berkshire Hathaway Inc., has invested in three freight railroads.
But investors who are thinking about following Buffett will have to determine whether strong business fundamentals or Buffett excitement drove the recent rise in rail stocks.
The three railroads companies Berkshire invested in — Fort Worth, Texas-based Burlington Northern Santa Fe Corp., Union Pacific Corp. and Norfolk Southern Corp. — all are trading near their 52-week highs. The same is true for the three other major North American freight railroads Berkshire didn't buy: CSX Corp., Canadian National Railway Co. and Canadian Pacific Railway Ltd.
The run-up in rail stock prices started about six weeks ago, when Berkshire Hathaway first disclosed its BNSF stake and Buffett said he'd bought into railroads. It continued last week when Berkshire revealed its investments in Union Pacific and Norfolk Southern and Icahn disclosed his company had invested in CSX.
Edward Wolfe, an analyst with Bear Stearns & Co., said in a research report that the high-profile rail investors have helped generate new interest in the industry.
"In addition to continued strong pricing and positive long-term secular demand fundamentals, we believe the strong run for the group so far in 2007 has been driven by newfound investor interest in the railroads," Wolfe said in a research note.
But interest by billionaires aren't the only thing driving railroad stocks up.
The most important factor in railroads' current and future profitability is the high cost of building a rail network, which makes new competitors extremely unlikely, said Randy Cousins, an industry analyst with BMO Capital Markets in Toronto. Cousins said he thinks Buffett recognized some of the competitive advantages the major railroads enjoy.
"I think he (Buffett) sees some powerful trends that are working for the railroad industry that aren't going to go away overnight," Cousins said.
Besides the near-monopoly power that major freight railroads enjoy, Cousins said, railroads also are helped by the fact that more businesses today need supplies delivered from afar, and shipping by rail is generally less expensive than shipping by truck.
Most of the major freight railroads also stand to benefit from the ethanol boom as more plants become operational in grain-growing states such as Nebraska, Iowa, and Illinois. The fuel additive is generally shipped by rail, and some ethanol plants will likely pay railroads to deliver grain to them.
Plus, railroads haul a diverse mix of products and commodities and can send locomotives wherever they are needed if the demand picture changes.
"The locomotive power doesn't care what's behind the train," Cousins said.
So if coal, for instance, were to suddenly become less popular with utilities because of pollution concerns, railroads could send more locomotives to the ports to haul containers full of imported goods.
Railroad executives have said they don't expect the demand for coal — which generally accounts for between 20 and 25 percent of each major freight railroad's revenue — to slow anytime soon. Both Omaha-based Union Pacific and BNSF hauled record amounts of coal out of Wyoming's mines last year.
Cousins said the biggest risk facing the industry is the chance government officials will decide to re-establish regulations that were dropped in 1980. But it's difficult to predict the chances of that happening.
Buffett rarely discusses the investments Berkshire Hathaway and its more than 60 subsidiaries make, and he didn't return calls for comment. But Buffett offered some insight into the decision to invest in railroads at Berkshire's annual meeting earlier this month.
Buffett said he made a mistake by not investing in railroads sooner, but he wasn't thinking about them two years ago.
Railroads' competitive position has improved somewhat, Buffett said, and as diesel prices continue to increase, shipping by rail instead of truck will only become more attractive.
Cousins said one train carrying a double stack of shipping containers can replace 220 semitrailer trucks on the highways.
"There are huge competitive advantages that play to the railroad industry," Cousins said.
Buffett said he doesn't expect sensational returns from railroads because it is such a capital-intensive business, but railroads are a better business than they used to be.
Andy Kilpatrick, the stockbroker-author of "Of Permanent Value: The Story of Warren Buffett," said he thinks the monopolylike power of railroads was the main attraction for Buffett. Kilpatrick also thinks railroads offered Buffett an outlet for some of Berkshire's billions that will generate reliable returns.
"It just seems to me they can be pretty sure they'll get a decent return," Kilpatrick said.
Cousins cautioned that investors should make their own determinations about whether railroads are a good investment. The calculation for Buffett, whose company typically holds onto its investments for long periods of time, may be different for individual investors.
"Mr. Buffett is not a day trader," Cousins said.
Buffett himself has said that one of the worst reasons to invest in something is because someone else bought it.