Maybe it seems quaint that an industry most associated with robber barons, the 19th century and the taming of the West even survives today, but railroads are still very much a significant part of the North American economic infrastructure. As major components of the transportation sector, railroad companies and their stocks are certainly worth the time and trouble to investigate further as their cyclical nature suggests that there will always be opportunities again in the future to buy (or sell) these stocks.

TUTORIAL: The Industry Handbook

What the Railroads DoTo a certain extent, railroad companies operate a pretty straightforward and obvious business – they charge companies for carrying cargo over their network of rails and railcars. In practice, it is a bit more complicated than that.

Major railroads in North America basically operate as duopoliesUnion Pacific (NYSE:UNP) and Berkshire Hathaway's (NYSE:BRK.A) Burlington Northern Santa Fe run routes throughout the Western U.S., Norfolk Southern (NYSE:NSC) and CSX (NYSE:CSX) control the East, and Canadian Pacific (NYSE:CP) and Canadian National (NYSE:CNI) operate throughout Canada. Again, though, the details are a little more complicated.

Within the rail industry, railroads are frequently broken up by category – Class I, Class II and Class III railroads. The distinctions between classes are a product of the railroad's revenue, with Class I being the largest and Class III being the smallest. In actual practice, though, these categories have questionable value – Kansas City Southern (NYSE:KSU) is technically a Class 1 railroad, but is much smaller than even the smallest of the "Big Six". Nevertheless, it is worth noting that there is profit opportunity not only in running large continental networks, but also operating smaller short-line railroads that connect industries to supply sources (like a power plant and coal mine) or connect companies and small towns to larger railroad lines. (Look at the big picture when choosing a company - what you see may really be a stage in its industry's growth. (For more insight see Great Company Or Growing Industry?)

Investors should also note that intermodal operations are an increasingly significant part of railroad company operations. Intermodal transport features the use of standardized containers that can be transferred from ship to rail to truck with no reloading or unloading of the freight itself. Where once trucks were required to transport freight from cargo ships to rail yards, now railroads can run lines straight to ports and offer customers faster, safer and cheaper service than before.

Why Rails MatterAlthough railroads have a long history, they are still very much relevant to the modern economy. Nearly half (43%) of all intercity freight transportation is handled by rail. While that number is impressive in its own right, it only tells part of the story. More than two-thirds of the nation's coal is transported by rail, and railroads carry a sizable percentage of the bulk shipments of chemicals, grains and cars in this country.

Rail also offers compelling safety and efficiency advantages – accident rates are far lower for trains than trucks, and a train can move a ton of freight over 430 miles on a gallon of diesel (the average for all major U.S. railroads in 2007). Granted, these comparisons are not apples-to-apples, as there are so many more trucks on the road, most truck accidents are not the fault of truck driver, and the emissions standards are different for the two industries. Nevertheless, railroads are still a very relevant mode of transportation today, and are likely to remain so for the foreseeable future. (Investors can find profitable companies - even in a recession. It's all about knowing where to look. See 4 Characteristics Of Recession-Proof Companies.)

Rail traffic is also a valuable proxy for economy activity. Carload traffic correlates pretty well with economic activity, as do the number of railcars deployed or held in storage. Likewise, intermodal traffic can offer important context on the state of international trade and the mix of traffic can offer signals as to what areas of the economy are notably strong or weak. For instance, lumber and building material shipments grew strongly into the housing bubble of 2008-2009, and then tumbled sharply.

How to Evaluate Rail OperatorsTo a certain extent, railroad companies should be evaluated like any other company – investors should look for revenue growth, strong margins, efficient capital deployment and so on. That said, there are particular facets to the rail industry that bear additional scrutiny.

The operating ratio is a major measure of profitability in the railroad industry. There is really nothing very mysterious about it – it is the company's operating expenses as a percentage of revenue, or the opposite of the operating margin, which uses operating income divided by revenues. An operating ratio of 80 or lower has generally been seen as "good," but having a target a bit lower; down in to the mid-70s is even better. (Find out how to put this important component of equity analysis to work for you, in Analyzing Operating Margins.)

Investors should also keep an eye on the composition of a railroad's top line growth. Volume growth is fairly straightforward, but pricing can tell investors something about a management's strategic approach. Some railroads have turned to long-term contracts as a way of surviving downturns more easily, but those contracts can come back to haunt the company during recoveries by leaving them locked into lower-price freight.

Ongoing capital expenditure needs are also a major consideration with railroads. It takes a lot of money to maintain thousands of miles of rail, as well as the freight-handling infrastructure and locomotives. Consequently, railroads do not often stack up so well in terms of their conversion of revenue into free cash flow. That said, investors should remember that these companies enjoy virtual duopolies in their markets and have lower effective costs of capital than many people realize. In other words, railroads must continue to spend large amount of money on their infrastructure, but a dollar spent on railroad infrastructure has historically offered a more certain (and lower-risk) return than a dollar spent on infrastructure in other industries. (For more, check out our Free Cash Flow Video.)

Issues and Dangers for the Rail InvestorHere are some of the issues that a rail investor should monitor:

  • Fuel CostsFuel can make up about 20% of a railroad's operating expenses. While the fuel efficiency of rails gives them an edge (versus trucks), in periods of rising prices, companies are not always able to fully hedge their costs or offset the risks with surcharges.
  • Labor CostsMost railroads see compensation and benefits comprise more than a third of their operating expenses, and the railroad industry is heavily unionized.
  • Capital DemandsRailroads have very high capital requirements and ongoing access to cost-effective capital is essential to their operations.
  • The Business Food ChainAs service providers, railroads do not "make" economic activity, but they do thrive or wither on the basis of it. If economic activity is sluggish, there is little that a railroad can do to stimulate demand or capture share.
  • CyclicalityAs demand for rail services is a byproduct of economic activity, railroads are cyclical businesses. While that means investors can always look forward to an eventual second chance to buy quality railroad operators, it also limits the viability of railroad stocks as long-term buy-and-hold positions.
  • Harder to ValueDue to their high ongoing capital expenditure requirements, railroads seldom look appealing by conventional discounted cash flow models. Investors can work around this by using lower discount rates (to essentially acknowledge and reward the duopoly position of rail operators) or less rigorous methods like price/book, EV/EBITDA and price-to-earnings.

The Bottom LineNo widget, computer, grain for food or automobile is worth a thing if it cannot move from the factory floor to the customer's hand. As the preeminent provider of freight transport in North America, railroads are an essential part of the economic infrastructure, and very much an investable industry. Though there are quirks and drawbacks to these companies and stocks, well-timed purchases can be very worthwhile investments.