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Tickers in this Article: NSC, CSX, UNP, BNI
Since hitting their 52-week highs in May, most of the railway stocks have tumbled, despite reporting general healthy results that were at, or just slightly below, analyst expectations.

Why such a negative reaction from investors?

It's a well worn piece of Wall Street wisdom that the fortunes of the rail stocks move very much in tandem with the overall economy.

As the evidence has mounted that the U.S. economy could be heading for a recession next year, cyclical stocks like the rails, have naturally been at the top of most investors' sell lists.

However, there are a number of factors at work in the railway business that could mute the impact of any further slowing in the economy; thus, limiting the anticipated cyclical damage to earnings and stemming any further declines in share prices.

For starters, the U.S. railway industry is essentially a four-player oligopoly. Over 80% of the country's rail business is carried by the four largest operators: Norfolk Southern (NSC) and CSX Corp (CSX) in the east, and Union Pacific (UNP) and Burlington Northern (BNI) in the west.

Competition is on an intra-regional basis and is muted, to some degree, by the need for co-operation with respect to shared assets such bulk commodity and container loading facilities. Price wars don't figure much given this type of industry structure.

Like the rest of the transportation sector, the railways have been feeling the effects of higher fuel prices. So far this year, fuel related operating expenses are up about 40-50%. However, when it comes to the long haul container business, rails still beat roads. The strong growth in this business over the last year bears this out.

Another factor that should limit the earnings downside for the rails, should we see a recession, is their strong exposure to the non-cyclical coal business. Hauling coal represents approximately one-quarter of railway revenues these days and is their most profitable operation. Increasing demand for thermal coal for power generation should keep this business on track throughout a recession.

Of the four stocks that make up this industry, the weakest performer since last May has been Norfolk Southern. Since hitting a 52-week high of over US $57, the shares have lost one-quarter of their value.

After reporting second quarter EPS of US $0.89 (just 3 cents below analyst expectations) the shares went into free-fall, dropping 8.5% on the day of the announcement with a massive volume spike. Since then, the shares have managed to rally back somewhat, managing to hold above what could very well have been a panic bottom for the stock.


The fundamentals also appear to support such a notion. At only a 11x forward P/E multiple, the stock is now trading near the low end of its historical forward P/E valuation range of about 16-10x. Given all this, my guess is that any further downside damage to the shares should be limited.

If another dip to the US $40 level does materialize, it might be a good time to consider adding a little railway exposure to your portfolio.

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