This Buffett Holding is Poised to Jump +33%

It’s no wonder Warren Buffett loves railroads so much — they’re a simple, easy to understand business. In fact, his investment vehicle Berkshire Hathaway (NYSE: BRK-B) has a stake in three of them.

This is exactly what Buffett was talking about when he said diversification is for people that don’t know what they’re doing.

Railroads have about as wide an will play right into the rail carriers’ hands.

All of these factors make the railroad business about as close to a legal monopoly as you can get.

Like most economically cyclical groups, earnings for the major railroads were hit by weak conditions as the economy slowed in 2008. The industry has taken steps to shore up profitability by furloughing workers, idling railcars and eliminating unprofitable routes as a result. But they are holding up well considering the collapse from historic highs in volume of goods transported.

All four of the major railroads agree the worst of the recession is over, but that economic conditions are less than ideal. Data published by the Association of American Railroads (AAR) indicates that rail volume trends are already improving early in the third quarter.

Railroads are sitting at attractive valuations in the meantime:

Company (Ticker) Current P/E 5-Year P/E Average Upside
Union Pacific (NYSE: UNP) 14.0 18.6 +33%
CSX (NYSE: CSX) 13.9 16.4 +18%
Norfolk Southern (NYSE: NSC) 13.0 14.4 +11%
Burlington Northern (NYSE: BNI) 14.6 15.8 +8%

Buffett owns Union Pacific, Norfolk Southern and Burlington Northern. His largest position is Burlington Northern — worth about $6.2 billion and making up more than 10% of Berkshire’s portfolio. The value for Union Pacific and Norfolk Southern is considerably less.

While Burlington Northern seems to be Buffett’s favorite railroad, the outlook for the entire industry will look promising when a recovery takes hold. Cyclical stocks often trade at high P/E ratios near the bottom of economic cycles because of depressed earnings conditions. In that light, these low valuations look even more attractive.