Tickers in this Article: UNP, BRK.A, CSX, NSC, CP, GWW, GE, FAST, ITW, DD
There is a great quote from the sci-fi series "Babylon 5" that says, "understanding is a three-edged word; your side, my side and the truth in between." That seems particularly relevant when looking at the discrepancy between what rail and industrial sales data says about the economy and what the market is saying about the near-term outlook for the broader U.S. economy. Not only is rail data showing solid momentum, but there is ample room still left to grow, before the stats have to carve out new highs. (For related reading, see A Primer On The Railroad Sector.) Investopedia Markets: Explore the best one-stop source for financial news, quotes and insights.

November Rail Data
Once again the Association of American Railroads' Rail Time Indicators has shown encouraging and positive news on the underlying state of the U.S. economy. Rail traffic, which is measured in carloads, rose 2.3% in November from the year-ago level and 0.9% from October. Of the reporting categories, 13 were positive, which is equal to last year and up one from the month of October.

Those numbers arguably don't do justice to the real strength of the industrial economy. Traffic was up 3.7% excluding grain and 3.2% excluding coal. Excluding both coal and grain, carload rail traffic climbed 6.1% from the prior year.

Is It Time for King Coal to Find a Successor?
Coal has traditionally been a major component of traffic for all U.S. major railroads, but it is worth wondering if that will always be the case. Coal is still the predominant energy source for American utilities, but it looks to be in long-term decline, due to cheap natural gas and environmental concerns tied to burning coal. The Powder River coal carried by Union Pacific (NYSE:UNP) and Berkshire Hathaway's (NYSE:BRK.A) Burlington Northern, has partially supplanted the Appalachian coal carried by CSX (NYSE:CSX) and Norfolk Southern (NYSE:NSC), but investors should wonder what the long-term future looks like. In the meantime, coal exports are helping to offset some of the damage.

There's also a bit of a boost coming from oil. Companies in the Bakken are pumping out copious amounts of oil, but the pipeline infrastructure just isn't there yet. So for now, that's good for the rails, with tankers and the short-line access to the fields; names that include Union Pacific, Burlington and Canadian Pacific Railway (NYSE:CP). While pipelines will eventually take away this market, there is still the chance for railroads to ship carloads of supplies, like sand, that are used in hydraulic fracturing in these fields. Still, a little perspective is in order; petroleum carloads jumped almost 19% in November to over 38,000, just under 6% of the total coal carloads.

Underlying Industry a Mixed Bag
Railroad is a derived demand industry, so clearly the health of rails is ultimately tied to the health of its customers. To that end, DuPont's (NYSE:DD) recent guidance reduction is a bit of a worry. DuPont's earnings have long had pretty close correlation to world GDP and chemicals are over 10% of the U.S. railcar market. Likewise, if demand for metal, aggregate or automobiles slackens, it will be a headwind for these operators.

There's a flip side, though. W.W.Grainger (NYSE:GWW) recently reported its November sales data and the information was encouraging. Total organic volume growth, arguably the most important number to tie in to rails, was about 10% and even though U.S. results were a little lower, the fact remains that Grainger and Fastenal (Nasdaq:FAST) continue to report that demand for industrial supplies is healthy. It's not hard to maintain some optimism, then, even if estimates for large industrials like DuPont, General Electric (NYSE:GE) and Illinois Tool Works (NYSE:ITW) are softening a bit.

The Bottom Line
Rails have rebounded nicely since October, and it is a little harder to find flat-out bargains these days. Sure, the volume and price momentum are healthy, but so too are the expectations. At the same time, business is changing; coal may be in slow decline and intermodal traffic is a small, but fast-growing, component of Class 1 railroad business models. While I would not be in any great hurry to sell out of a quality railroad stock, investors looking for bargains may instead want to focus on trucking or air freight as better values. (For additional reading, check out 5 Must-Have Metrics For Value Investors.)

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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