An ideal investment for the long haul

Still, the sector has had its fair share of issues over the past few years. In 2015 and 2016, total rail traffic volume dropped by 2.3% and 5%, respectively, due to falling energy and coal demand. Declining coal usage, in particular, has ravaged a number of companies. According to the Association of American Railroads, U.S. rail coal tonnage has fallen by 850 million tons of coal in 2007 to 492 in 2016, while carloads of coal have fallen by about 44% over that time frame. The volume falloff has impacted stock prices, with the S&P 500 Railroad sub-index dropping 21% between November 2014 and January 2016.

However, that drop is just a blip in a history of strong gains. Since January 1990, the subindex has climbed by 2,081%, compared to 566% for the S&P 500. It's also up 75% since its January 2016 low and 15.5% for the year to date as of this writing.

Turning point for trains

Indeed, railroads are in the midst of a minor resurgence. Volumes have started to rise again, up 8.3% year over year, while coal volumes have also climbed by 16% year to date. While coal's dominance isn't coming back, says Schoonmaker--utilities will ultimately continue using cheaper and cleaner natural gas over coal--the recent increase in coal volumes are giving some rails, in particular eastern U.S. railroads like  CSX (CSX) and  Norfolk Southern (NSC), a bit of a boost.

Railroad volumes in general should grow in line with GDP, with most of their product lines growing at a modest pace. However, intermodal transport--or shipping that involves multiple modes of transportation, such as ships, trucks and trains--is a bright spot for railroads, says Schoonmaker. He thinks intermodal industry gross revenues should expend by 5% on average between 2017 and 2020, while container volume growth will climb by about 3.5%. That's faster than other parts of the businesses.

Typically, intermodal transport involves carrying a variety of freights to a number of destinations. While it is more complex than what the rails may be used to--they need to fill hundreds of shipping containers for it to make sense, rather than just transporting a load of coal from a mine to a plant--transporting goods by train is much cheaper and cleaner than trucks, the main competitor in the intermodal transport arena.

"Trucks may be faster and offer point-to-point service, but rails are cheaper and greener and have ample capacity," says Schoonmaker. "And if each train is pulling 200 containers instead of one, you can see how the economics can be in favour of rails."

It may also be a good time politically to own railroads. Unlike other industrial companies, railroads invest billions of dollars into their businesses every year, mostly to fix tracks, cars and other infrastructure. About 16% of a company's revenue is reinvested annually, says Schoonmaker, which is a much higher rate than other transportation companies.  United Parcel Service (UPS), for instance, has hundreds of shipping terminals, trucks and aircraft, and thousands of employees, but we project it will reinvest 6% of its revenues into the business going forward, he says.

If President Donald Trump does indeed cut corporate taxes in the United States, the savings will help railroads immensely. While other industrials might use the excess cash to buy back shares or raise dividends, the railroads are more likely to reinvest, and that could be a boon to stock prices.

Operation ratio reduction

One of the main ways railroads improve profits is by lowering their operating ratios, a term used to indicate a company's operating expenses as a percentage of revenues. It's the most important metric in the railroad industry, and the lower it gets, the better. Reducing this ratio has been easier said than done for most companies. But thanks to one company's recent management shakeup, that ratio could fall faster at railroads than it has in the past.

 On March 6, legendary railroad CEO Hunter Harrison took the helm at CSX. Harrison, who was named Morningstar's CEO of the Year for 2013, has a history of turning underperforming companies into industry powerhouses by dramatically cutting expenses and finding new efficiencies, which then lead to lower operation ratios. In the fourth quarter of 2012, two quarters after Harrison took over,  Canadian Pacific Railway (CP) had a 74.8% operation ratio. It was about 56.2% in the fourth quarter of this year, which is second to  Canadian National Railway (CNR), a company Harrison also transformed. There's no reason to think that he can't drive down CSX's fourth-quarter 2016 operating ratio of 69.4%.

"We believe that new CEO Hunter Harrison will drive CSX's operating ratio improvement at a pace faster than the rail could otherwise manage," notes Schoonmaker in his latest report. That will put pressure on Norfolk Southern and even the western U.S. railroads to reduce their own operation ratios.

Worth the price

The main drawback to railroads today is valuation. The average railroad stock in Morningstar's coverage universe is trading about 3% above Morningstar's fair value estimate, suggesting that it's fairly valued. However, the railroads aren't really like other transportation stocks, which is one reason for the higher valuation levels. Railroads have an almost impenetrable moat: no one is building a new cross-continent railroad system. Because of that, competition is minimal, which means railroads overall can raise prices by about 3% per year. In fact, it's reasonable to expect these companies to grow earnings by 6% every year, with volumes growing by about 1.5%, prices by 3% and margin improvement adding 1%, says Schoonmaker. Add in some share repurchases, and growth is now in the mid-to-high single digits.

Despite its current price, Schoonmaker thinks  Union Pacific (UNP) looks relatively attractive. It's trading at a 3% discount to fair value as of this writing, according to Morningstar, and offers a 2.2% yield. It produces free cash flows of 20% of revenue, which is second only to Canadian National--and Union Pacific is twice the size. "It's tremendous cash generation," Schoonmaker says.

In any case, it's hard to go wrong with railroads over the long term. The key, though, is to hang on. Investors won't see massive growth in any one year, but, as the industry has proven historically, it can still post above-average returns over time.