Are Railroad Stocks Overpriced? – Canadian Pacific Railway Limited (USA) (CP), Union Pacific Corporation (UNP)

Some investors have plunged into railroad stocks, believing they will benefit from a stronger North American economy in 2013. But are they overly optimistic?

Transportation stocks, as measured by the Dow Jones Transportation Average, gained 13% in the first two months of 2013, double the gain made in all of 2012.

Railroads reflect the health of their economies. For 2012, the US economy grew 2.2%, up from the 1.8% growth of 2011. And the Canadian economy in 2012 expanded 1.8%, down from the 2.6% growth in 2011. Both economies had sluggish fourth quarters, but this has been a slow recovery with choppy ups and downs.

Stock in Canadian Pacific Railway Limited (USA) (NYSE:CP) gained 24% year to date through March 5, and is now sporting a 20 forward price/earnings ratio.

Canadian National Railway (USA) (NYSE:CNI) gained 12% year to date through March 5, and Union Pacific Corporation (NYSE:UNP) gained 11% through March 5. I believe CN and UP offer investors immediate value opportunities. Both stocks are cheaper than Canadian Pacific Railway Limited (USA) (NYSE:CP) based on as price/earnings ratio, and their prospects for growth are decent, especially in the energy sector.

The forward P/E on CN and Union Pacific Corporation (NYSE:UNP) are 16.65 and 14.71, respectively — which is lower than the multiple that Warren Buffett paid for Burlington Northern Santa Fe in 2010.

Buffett paid $100 per share, or 18 times forward earnings, for BNSF for Berkshire Hathaway Inc. (NYSE: BRK.A). He called his purchase an “all-in wager” on the U.S. economy.

BNSF’s revenues increased 7% in 2012 to $20.8 billion, according to Berkshire Hathaway’s 2012 annual report. Shipment volume in 2012 saw consumer products up 4%, industrial products up 13%, partially offset by declines in coal, down -6%, and agricultural products down -3%. BNSF’s earnings in 2012 were up 13.4% to $3.3 billion.

Grain shipments by railroads were down in 2012 because of drought. Demand for coal fell because utilities switched to cheaper-priced natural gas to burn in their power plants.

Union Pacific lost some coal business, but had less exposure than CSX Corporation (NYSE: CSX) or Norfolk Southern Corp. (NYSE: NSC). UP also lost some grain business.