News Analysis date published New: 
Thursday, October 14, 2010 - 16:50
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Friday, October 15, 2010 - 09:23
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Thursday, October 14, 2010 - 16:50

Great Returns Are Available in the Last Place You'd Expect

Thursday, October 14, 2010 - 4:50pm

If you were asked to name the types of stocks with the greatest appreciation potential, which sectors would come to mind: tech, energy, financial services, health care? Investors flock to those and other well-known industries for good reason. They all have a history of good long-term stock performance.

Following the crowd has a downside, though. Popular assets can be more prone to bubbles like the one in real estate a couple years ago or the one that arguably exists in gold right now. When bubbles burst, as they often do, investors lose lots of money fast. [Forget Gold -- Here's Another Resource Play With Double-Digit Potential]

That's why I'm a fan of diversifying into areas that are less-traveled but can still offer performance. One low-key sector in particular has been doing beautifully, spiking about +140% from a March 2009 bottom.

I wouldn't necessarily expect results like that going forward, especially from the industry as a whole. But as the economy slowly picks up steam, certain stocks in the sector are apt to pull ahead. I'm talking about railroad stocks, and the right ones could deliver double or even triple-digit gains in the next few years due to rising freight demand. Here are several to consider.

Kansas City Southern (NYSE: KSU). Shares of this company currently trade at about $41.25. However, based on forecasted earnings growth averaging nearly +16% annually, they could rise into the $70 to $80 range -- a +70% to +90% jump -- within a few years.

Because coal-fired power plants no longer keep large coal stockpiles, regular shipments to such plants will be an important source of Kansas City Southern's future earnings. Another important source will be service additions, like a new line in southeastern Texas (which should make the company more competitive with truckers in that area) and an exclusive franchise to serve the west Mexican Port of Lazaro Cardenas, the largest seaport in Mexico.

Also, following a two-month service interruption, an existing revenue source is once again operational: the company's rail system in northeastern Mexico, which suffered severe flood damage during hurricane Alex this past summer.

Norfolk Southern (NYSE: NSC). Return projections for Norfolk Southern aren't quite as attractive as those for Kansas City Southern, but they're certainly worth a look. From the current price of about $62, the stock could conceivably trade in the $100 to $110 range in a few years -- an increase of +60% to +75%. The stock currently sports a decent 2.4% dividend yield, though that may gradually drop to less than 2% as shares appreciate.

Norfolk Southern is promising because freight shipments have been up, rising +22% in the second quarter, for example, mainly on strong coal exports. The Heartland Corridor, a new line resulting from a partnership with three states and the federal government, improves efficiency greatly by knocking a full day off a key route between the Port of Norfolk and the Ohio Valley.

An important variable: the board of directors authorized the repurchase of 50 million of Norfolk Southern's 370 million outstanding shares through 2014. If the company is as proactive about buybacks as it has been in the past, its stock could rise much more than I've described here.

RailAmerica (NYSE: RA). Whereas I consider Kansas City Southern and Norfolk Southern surer investments with very good appreciation prospects, I see RailAmerica as a riskier stock with triple-digit potential. In a few years, its shares may well be trading +95% to +140% higher than their current price of about $10.20.

That's because RailAmerica has been vastly expanding capacity and increasing freight traffic. Plus, it serves several ports and has connections to Asia, where there's high demand for all sorts of products. It recently bought Atlas Railroad Construction, which should greatly facilitate its own expansion efforts.

As you may realize when looking up the stock in your own research, though, RailAmerica is a small-cap company -- which usually means more risk. And its stock hasn't even been trading for very long, either (since 2008).

Action to Take --> Consider adding railroad stocks to your portfolio. Although they're not known for it, many have excellent appreciation potential. Provided the economy cooperates, and I think it will, chances are that potential will be realized.

Railroad stocks can also reduce overall risk in your portfolio through diversification. When was the last time you heard about a railroad bubble?

Tim Begany does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.