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Railroad stocks took a breather over the past week after surging sharply higher over the past six months. In aggregate, the sector is trading down 1.9% over the past month when the rest of the S&P 500 has soared higher. Some see this as a great entry point in a sector that has attracted many savvy investors in the past, including billionaire Warren Buffett.

Why Railroads?

Railroad companies are somewhat difficult to grasp. Some investors suggest they are defensive stocks, since they have long-term contracts that can weather a recession. Others call them growth stocks, since their business inevitably picks up when the economy does. And either way, they tend to outperform when energy prices are high as people shift off-road.

While these companies built up a lot of debt building infrastructure, they were able to significantly slim down their costs during the economic crisis in 2008. Many companies renegotiated worker contracts, refined their cost structure, and emerged in a much stronger state than they entered at just the right time for a recovery.

Some of the top performers over the past year have included:

  1. Kansas City Southern (NYSE:KSU) + 27.9%
  2. GATX Corporation (NYSE:GMT) +21.3%
  3. Genesee & Wyoming Inc. (NYSE:GWR) +14.5%
  4. Union Pacific Corporation (NYSE:UNP) +14%
  5. Norfolk Southern Corporation (NYSE:NSC) +13.5%

Union Pacific is the Safest Bet

Union Pacific is perhaps the largest and strongest player in the industry. The company has significantly outperformed both the S&P 500 and its peer group over the past five years (see chart below) and should continue to do so. With a modest 16.5x price-earnings ratio and a 2.16% dividend yield, the stock is perfect for both growth and income investors at these levels.


(Click to enlarge)

During 2011, the company reported a 15% jump in operating income to $5.7 billion and net income of $3.3 billion, or $6.72 per share. And perhaps more importantly, the company had record free cash flows of $1.9 billion during 2011. This gives it ample room to both expand and continue to pay its healthy dividend yield to investors.

CSX is the Most Undervalued Play

When most of the industry was soaring higher, CSX Corporation (NYSE:CSX) fell nearly 7% over the past 52-weeks. The stock now trades with a low 13.1x price-earnings multiple, a PEG ratio of just 0.76, and a 2.19% dividend yield. Last quarter, the company reported an 11% increase in revenues to nearly $3 billion and a strong 70.4% operating ratio.

Of course, there is a great reason for CSX's undervaluation - it's debt to equity ratio. But recently announced strategic growth initiatives should help enhance its growth to eliminate that problem. These initiatives are focused on building new terminals, focusing on coal exports and improving its service with a Total Service Integration initiative.

Finally, the company has been very friendly to shareholders by increasing its cash dividend nine times over the past five years and implementing a new $2 billion share repurchasing that is expected to be completed by the end of 2012. Combined, these could also help close its discount to its peers and unlock value for shareholders.

Source: Railroad Stocks: Time To Stock Up For A Recovery