Will Buffett’s Railroad Bubble Derail Transportation ETF?

by on December 3, 2009 | ETFs Mentioned:

Despite the fact that shares of Berkshire Hathaway have lagged far behind broad market benchmarks this year, the events of the last month have shown that the investment community still hangs on Warren Buffett’s every word and tries to draft his every move. Buffett’s Berkshire Hathaway announced in early November that it would purchase the shares it didn’t already own in railroad operator Burlington Northern Santa Fe at a premium of nearly 30%, setting off a run on railroad stocks. While his bullish outlook on the U.S. economy in general (and the railway sector in particular) has delivered some big short-term gains, some believe it has also created one of the biggest bubbles in the U.S. economy.

BNSF Railcar

Rail cars may seem antiquated, particularly to younger investors, but the railroad industry is still big business. Rail accounts for 43% of the freight hauled across the U.S., and is a more eco-friendly (and downright modern) alternative to an outdated highway system. Burlington is one of the largest railway operators in the country, with more than 32,000 miles of track and 220,000 freight cars moving at any given time. In 2008, BNI generated revenue of more than $18 billion.

Buffett calls the $34 billion deal, the largest he’s ever done, “a bet on the U.S. economy,” essentially anticipating that rail activity will rebound as the recovery progresses, consumer confidence rebounds, and manufacturing activity sees an uptick (although he recently joked “this is all happening because my father didn’t buy me a train set as a kid”). BNI shares surged on news of the takeover, as did stocks of several rival railway operators.

Some astute investors have now noted that a clear pattern is emerging. The November jump in railroad stocks was the third time in as many years that Buffett has given this sector a shot in the arm. Following Berkshire’s purchase of an initial 11% stake in BNI in April 2007, rail stocks outperformed the S&P 500 by a wide margin. Similar results occurred when the company upped its stake above 15% six months later.

“Buffett Bubble”

But railway stocks quickly gave back significant portions of the gains they initially recorded following the first two transactions, and some expect a similar reaction this time around. So it now seems possible that another “Buffett bubble” is forming under railway stocks, with a potential pullback coming. UBS warned clients of this potential development recently, downgrading Union Pacific, the company it believes has the most to lose if history repeats itself.

While it would be foolish to doubt Buffett’s brilliance, it would be equally unwise to hold him out as infallible. Aside from the technical end to the recession, there’s been little hard data to support a rosy outlook for the rail industry. Unemployment continues to rise, recently breaking through the 10% mark and still headed higher. Factory activity, which is closely tied to railway activity, unexpectedly declined last month, as the Institute for Supply Management’s key index of manufacturing activity fell to 53.6 from 55.7 in October. We know Buffett invests for the long term, but it seems those rushing in after him may be creating a short-term divide between market prices and intrinsic values.

If a Buffet bubble is indeed forming under railway stocks, it may also be time to reevaluate holding in certain commodity-intensive firms. Burlington is the largest transporter of coal and grain – each year it hauls enough coal to supply one out of every 10 homes in the nation and hauls enough grain to supply 900 million people with a year’s worth of bread. For many investors, the Burlington deal translated into a Buffett endorsement of the coal and agribusiness sectors. The PowerShares Global Coal Portfolio (PKOL) rallied more than 17% in November, and the Market Vectors Agribusiness ETF (MOO) added 12% for the month.

Transportation ETF: Too Far Too Fast?

Company IYT Weight* November Gain
Burlington Northern Santa Fe 13.2% 30.5%
Union Pacific 8.5% 15.2%
CSX Corp. 5.0% 13.1%
Norfolk Southern 4.9% 11.0%
*As of December 1, 2009

The iShares Dow Jones Transportation Average Index Fund (IYT) has surged over the last month, gaining more than 9% in November as stocks of railroads soared. In addition to Burlington Northern Santa Fe, IYT has major weightings in BNI competitors Union Pacific, CSX Corp., and Norfolk Southern.

IYT isn’t a pure-play railway ETF – it has allocations to logistics providers (such as C.H. Robinson) and shipping companies (such as FedEx and United Parcel Service) – but its tilt towards rail operators certainly makes it vulnerable to a potential bubble in the sector. Overall, IYT has 20 holdings spread across railroads (31.6%), delivery services (23.5%), trucking (19.9%), and marine transportation (8.7%) sectors.

IYT charges an expense ratio of 0.48%, and has returned almost 15% so far in 2009, much of it added in the last 30 days. If the bubble is indeed about to pop, a short position in IYT would become an attractive investment play.


Disclosure: No positions at time of writing.