On Monday, Berkshire Hathaway Inc. disclosed its 10.9% stake in Burlington Northern Santa Fe (BNI: NYSE) worth $3.4 billion. To no one’s surprise, investors around the globe jumped on the Buffett express. Burlington’s share price rose 6.5% on the announcement.

And Buffett didn’t stop there. Berkshire confirmed it has also acquired stakes in two of the three remaining North American railroads: Union Pacific (UNP: NYSE), CSX (CSX: NYSE) and Norfolk Southern (NSC: NYSE).

Many people are speculating on the remaining two. I’m having more fun speculating on the one left behind.

Imagine the fate of the CEO whose company Buffett emitted. Talk about a public rebuke. Which one of the remaining three wants to step into his next board meeting as the “one” Buffett shunned?

Personally, my money is on CSX. I have no propriety knowledge other than a close friend who used to work there. He always described CSX as the black sheep in the American railroad family. To him, Norfolk Southern was the overachieving big brother.

That’s hardly an educated guess. But less I digress.

No one really knows why Buffett fell in love with railroads all of the sudden. Burlington certainly carries Buffett-like characteristics: Consistent earnings growth (22% annualized over 5 years), impressive margins and limited competition.

But none of the railroads typify your typical Benjamin Graham value play. The stock trades for more than three times book with limited liquidity and tangible debt.

So what was Buffett thinking? It’s anyone’s guess. But the prevailing consensus believes globalization…specifically, moving the major staples of trade — things like coal, oil, cars, and clothes…in other words, basic commodities and finished goods — from producer to consumer is the long-term trend at play here.

I’ll buy that.

It was about this time in 2002 that a rebirth in the tangible assets sector really began. Much of that growth can be directly attributed to the insatiable demand for raw materials that the developing giants known as China and India are now consuming.

These countries are still in the early stages of development. It takes about 30 years to go from an agrarian society to an industrial one. China is about one-third of the way there. China will continue to import commodities to sustain this enormous transition. India will do the same.

Furthermore, the golden era of stocks (1982-2000) directed capital in about every investing avenue except natural resources and raw materials. Hence, limited demand caused a decrease in available supply.

Now the entire world can’t get enough copper, zinc, lumber and oil. But bringing on new production takes time. Supply can’t catch up with demand overnight. In fact, it’s going to take quite some time, especially when you throw in the consumption potential of India and China (37% of the world’s population) to the mix. Consequently, commodities (the market for the essentials) will remain tight for the foreseeable future.

And commodity consumption won’t be limited to emerging markets alone. Let’s not forget… The United States has begun to embrace alternative energy. And the two greatest oil alternatives, coal and corn, are shipped by train.

So transport stocks like Burlington certainly play into this long-term trend. And considering rising fuel prices affect trucks more than trains, this idea begins to make more and more sense.

But many feel it’s too late. Many believe the upside is already priced in. Well, that may be true.

But I think there may be another way to piggyback Buffett’s investment thesis.

I’m talking about dry-bulk shipping.

Despite what many think, dry-bulk shipping companies are relatively new to public markets. In the past, most companies have stayed in private hands.

Better yet, these companies are all classified as small-cap stocks. The average industry market cap is just over $800 million. Therefore, companies this small (in fact, the entire dry-bulk industry) don’t effectively cross the radar screen of big-time investors like Berkshire Hathaway.

That’s where we come in.

As I’ve written before, one might think, with lightning fast courier services, airplanes, FedEx and UPS — a whole slew of modern transport services — that using ships to transport cargo would be antiquated.

That assumption couldn’t be further from the truth.

Shipping still serves as the world’s economic circulatory system. This business connects the world in ways technology never will. Roughly 90% of the world’s exports are still transported by ship.

Shipping is, and will remain, irreplaceable on the world stage. We can’t live without it. It won’t be replaced. It’s been around for centuries. Until we reach a stage of technological innovation in which the major staples of trade — things like coal, oil, cars, the finished products that fill Wal-Mart stores — can be disassembled, one molecule at a time, and instantaneously beamed to another location, our current means for commerce will remain the most efficient.

Readers of Penny Sleuth may remember this argument. Last December 1, I highlighted the small-cap shipping stock Excel Maritime Carriers (EXM: NYSE).

At that time, you could’ve bought the stock for 90 cents on the dollar for less than four-times cash flow. That’s not bad considering the stock offered an earnings yield of 26.3% on a company that produces operating margins well above 60%.

That Friday, shares of Excel Maritime closed at $13.76. They opened for $19.30 today. That’s a 40% return in just over four months.

The stock still trades at impressive multiples.

* In Millions

Now I’m hesitant to say this stock provides a fully adequate margin of safety for long-term investors (I want to stress long-term, especially in such a cyclical industry!). But, once again, I will give you this.

First, the business is easy to understand.

We’re not talking biogenetics or even the most basic automotive technology for that matter. The business is much more simple. You can have all the coal in the world, but it’s worthless if you can’t get it from point A to point B. That’s all shipping does…it transports commodities and finished goods from one port to another…nothing more, nothing less.

Second, the company operates with a sustainable long-term competitive advantage.

Like railroads, shipping is a very capital-intensive business. Shipping is a very capital-intensive business. Vessels can cost upwards of $50 million a piece. Hence, the barriers to entry in this business are quite high. But once you’re in, the margins are remarkable.

Finally, maritime shipping margins offer great downside protection.

The approximate cost of operating a dry bulk carrier on a daily basis is somewhere between $4.5 and $5 thousand dollars.

Depending on the size of the fleet, shippers can charge anywhere from $7,000 to $29,000 per day.

You’ll be hard pressed to find a comparable capital-intensive industry with unit margins like these.

You Be the Judge…

I’ve said it once and I’ll say it again.

The risk here lies in the assumption that the company can maintain steady revenues for years to come.

Well, if you believe globalization isn’t just a fad… If you’re convinced BRIC (Brazil, Russia, India and China) countries will continue to grow, there will be ships on the open seas to service their needs.

You can be sure there will be hiccups from time to time…some driven by excess capacity…some will be driven by nothing more than market exuberance. But as long as the fundamentals supporting your investment are still there, I believe pullbacks to be excellent opportunities to add to your position.

Until Next Time,
Christopher Hancock
April 13, 2007

P.S.: When you talk about international growth, you can’t forget about the immense strain on the Earth’s water supply. In fact, some of Wall Street’s biggest players have been making money off these “Invisible Investments” for years.

Christopher Hancock

Christopher Hancock lives and breathes emerging markets. He travels extensively and utilizes his contacts across the globe to recommend the best international investments in the world. After working with Citigroup in Hong Kong on the challenges and opportunities associated with the forthcoming RBM flotation reform, Christopher left many of his friends behind and decided to return to the States to pursue a career in equity research.

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