Thursday, April 12, 2007

Railroad and Shovels

Mr. Buffet's Berkshire Hathaway recently acquired a 10% in Burlington Northern Santa Fe. When the oracle speaks, the street listens. The railroad sector got a nice lift. I am surprised by the market's reaction, rather than Mr. Buffet's new interest in an "out-of-favor" industry.

Since 2006 or even earlier, the large build-out in corn-based ethanol refineries and the sharp demand increase in coal for power generation have provided ample indication about the prospect of railroad transportation: connecting commodity producing regions with refineries, power plants, and exporting ports. While the short-to-medium profit outlook on the final energy product is questionable, I had my bets on its supporting industry, railroad particularly. A good analogy is our historic Gold Rush economy. The folks who became rich were not the one who found gold in the Wild West, but the one who sold shovels and other mining tools to the gold miners. The rationale behind Mr. Buffet's decision is quite simple yet logical.

What surprised me the most is the market reaction. The market had known such a fundamental shift for a while but did not really price in the railroad stocks. The sector jumped because Buffet bought it, rather than the fundamentals made sense.

Along that note, I think the market is still way too optimistic about the corporate earnings growth. The current price levels have a lot of room on the downside once people realize the slowdown in growth is a reality. However, as long as the excessive liquidity still flushes around, the equity market will attempt new highs in the near-term. The sudden tightening in the credit market will play the catalyst to drive up the risk premium in the equity market.

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