Will This Surprising Industry Derail Buffett's Dreams?

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Warren Buffett always wanted to own a railroad. That dream came true two years ago, with Berkshire Hathaway's (NYS: BRK.A) (NYS: BRK.B) purchase of the Burlington Northern Santa Fe. But could a lawsuit now turn that dream into a nightmare?

The modern age of railroads
Believe it or not, railroad stocks offer some of the best returns in the market today. As the following chart illustrates, Union Pacific (NYS: UNP) , Norfolk Southern (NYS: NSC) , CSX (NYS: CSX) , and Kansas City Southern (NYS: KSU) have all beaten the S&P 500 resoundingly over the past decade.

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Source: Yahoo! Finance, as of 9/20/2011.

This surprising fact stems from two related trends in the railroad industry. First, it has consolidated dramatically since Congress deregulated the industry in 1980, going from more than 40 railroads to only seven today. Of the seven that remain, only four really matter: CSX, Norfolk Southern, Union Pacific, and BNSF, which collectively account for 90% of the industry's revenue.

Second, the industry's operating yield -- a proxy for shipping rates -- has almost doubled since 2004, as the chart below illustrates. And this increase doesn't account for fuel surcharge, which were introduced at the same time, and which purportedly tripled certain shippers' rates.

 

Source: U.S. Department of Transportation, Research and Innovative Technology Administration, Bureau of Transportation Statistics.

Companies as large as DuPont (NYS: DD) and Occidental Petroleum (NYS: OXY) complain that their rates have doubled in the last five years alone. And while the railroads used to negotiate, Keith Smith, the chief procurement officer at DuPont, says that's no longer the case. According to a recent article in Fortune magazine, when one customer confronted CSX about this, it responded: "Because we can."

With this in mind, it's no surprise that Union Pacific, CSX, Kansas City Southern, and Norfolk Southern have all markedly increased their earnings per share over the past five years.

Have railroads gone off the track?
Although these returns are great for shareholders, the higher rates underlying them prompted shippers to file suit for price fixing. They claim that top executives from the big four railroads agreed to raise rates and introduce fuel surcharges during an April 2003 dinner in Litchfield Park, Ariz. If true, this alleged collusion would violate the Sherman Antitrust Act.

Speaking as an attorney, I don't think the facts here look good. No one disputes that railroad executives discussed shipping rates and fuel surcharges at the Arizona meeting, or that those rates and surcharges began their ongoing ascent shortly thereafter. The only question is whether the railroad leaders coordinated those rate hikes during the Arizona meeting. If so, the railroads will face antitrust liability. If not, they'll have a virtual blank check to continue the status quo.

Should you steam ahead?
The progression of these cases will dictate how railroad stocks perform in the years to come. Consequently, if you own or are thinking about buying into this sector, I strongly recommend that you add these stocks to your watchlist by clicking here. Otherwise, leave a comment below, and let me know whether you think regulations should be reinstated to protect shippers from the railroads' alleged price-gouging.

At the time this article was published Fool contributorJohn Maxfielddoes not own shares in any company mentioned above. The Motley Fool owns shares of Berkshire Hathaway.Motley Fool newsletter serviceshave recommended buying shares of Berkshire Hathaway. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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