With the United State's economic situation finally beginning to move in the right direction, freight traffic has been picking up steam. Tracking a variety of transportation companies including trucking, marine and air traffic, the iShares Dow Jones Transportation Average (NYSE:IYT) has rallied nearly 23% in the last 12 months. However, one group has performed even better.

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The North American railroads have dramatically improved their margins since the so-called "rail renaissance" that began in the mid-2000's and are poised to take advantage of the continuing economic growth. Overall rising demand for commodities has helped the sector rebound from 2009 recession lows. This, combined with the continued focus on the nation's infrastructure, means that rail traffic will be in demand. Investors looking for a way to play the increasing economic growth should take notice of the sector.

Freight Rebound
Overall, the North American railroads experienced increases in hauling traffic throughout 2010. Total carloads increased 7.3% and intermodal volume increased by nearly 14.2% throughout the year. While the data is still below levels achieved in 2008, the current year's numbers are showing signs of improvement. Through 2011's first seven weeks, carloads were up 5.1% and trains shipped 1.9 million containers, up 8.4% compared with traffic from the same period in 2010. Currently railroads ship less than half of the freight in America, leaving plenty of room for growth. This increase in shipping has many analysts bullish on the railroad sector and economy in general. Analyst's estimate that railroad revenue growth should exceed that of U.S. GDP for the next three to six years.

Railroads are also benefiting from high crude oil and gasoline prices. Trains are more fuel efficient than traditional diesel trucking so moving goods by rail reduces greenhouse omissions, especially as the industry continues to improve on engine design. Railroad companies have doubled their efficiency since 1981, plowing more than 40 cents per dollar they earn, back into their networks. Freight railroads have invested more than $460 billion since 1980 to maintain and improve their tracks, bridges, tunnels, locomotives, freight cars, and other infrastructure and equipment. Estimates by the Association of American Railroads suggest that it would cost shippers almost $70 billion more per year if all freight moved by rail were shifted to truck.

These infrastructure and improvement investments have provided an increase in rail productivity by 174% since 1981 and average inflation-adjusted rail rates decrease of 55%.

Getting a Ticket to Ride
As consolidation in the industry has been rampant over the last few years - Berkshire Hathaway's (NYSE:BRK.B) mega-purchase of Burlington Northern-Santa Fe Railway comes to mind - only a handful of railroad providers are left. However, despite their strong runs over the last year, the sector is still undervalued. Forward P/E's for the sector trade at an average 12, below the normal 15. In addition, the overall sector pays consistent growing dividends, even raising payments during the recession. Investors looking for value among the stock market's recent run-up should consider the railroad sector.

Criss-crossing 23 different states, Union Pacific (NYSE:UNP) is the nation's largest railroad. Capital spending totaled $2.5 billion in 2010 and has helped UNP become one of the most efficient railroad stocks with an operating margin of 29.4%. Analysts expect 13% revenue growth in 2011. In addition, Union Pacific raised its dividend 41% during the recession. Similarly, CSX (NYSE:CSX) has rapidly been improving their operating margins as well.

Offering the sectors highest dividend yield, Kansas City Southern (NYSE:KSU) recently reported a double digit growth expectation. Norfolk Southern, another major player, operates one of the most extensive intermodal networks in the East and is a major transporter of coal and industrial products.

Orders for new railway freight cars rose to 10,853 in the fourth quarter. Finally, any increased rail traffic will benefit the producers of rail cars, tracks, ties and other industrial equipment used in the sector. Both American Railcar Industries (Nasdaq:ARII) and FreightCar America (Nasdaq:RAIL) both manufacture various railcars and will profit from the long term increase.

Bottom Line
As the economy continues to improve, so should the returns of the railroad operators. The sector is cheap based on historical measures and is experiencing increases in freight traffic. For investors looking for values among the market's recent rise, railroad stocks such as Genesee & Wyoming (NYSE:GWR) make ideal portfolio positions. (Without this risk-reduction technique, your chance of loss will be unnecessarily high. See The Importance Of Diversification.)

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