PORTFOLIO STRATEGY - Profiting from the long haul

Coal is the double-edged weapon in America's energy arsenal. Already the source for half of all U.S. electricity, known reserves are plentiful enough to last 250 more years. But the burning of coal is a major source of carbon dioxide -- considered a chief contributor to global warming -- as well as toxins like sulfur dioxide, nitrogen dioxide and mercury. Newly empowered Democrats at the state and federal levels are vowing to tighten pollution regulations. Torn between the promise and the risk, some portfolio managers are finding what they believe is a safer way to play the sector: Buy railroads that transport the stuff.

"The railroad industry is one of the greatest growth industries in America today," says Donald Hodges, chairman and portfolio manager of Hodges Capital Management, which oversees about $1 billion in assets, including the $602 million Hodges Fund, a go-anywhere, multicapitalization equity fund that has returned an average annual 19 percent over the past five years.

Hodges, based in Dallas, Texas, owns no coal stocks but holds 245,000 shares of Fort Worth, Texas­based Burlington Northern Santa Fe Corp., which has 32,000 miles of track in 28 U.S. states and two Canadian provinces. He also owns 110,000 shares of Omaha, Nebraska­based Union Pacific Corp., whose rail system spans 23 western states, making it the biggest rail company in North America. At the stocks' recent prices of $79 and $99, respectively, Hodges's railroad holdings were worth a combined $30.2 million.

Even though regulators are increasing their scrutiny, Hodges expects U.S. utilities to build 70 new coal-burning plants during the next three to four years. He says many plants will be fired by abundant, relatively inexpensive low-sulphur coal from the Southern Powder River Basin in Wyoming and Montana that will be transported eastward on long and increasingly efficient trains of 120 or more railcars. Burlington Northern and Union Pacific own the long-haul track for these trains and thus command a chokehold on Powder River rail traffic. (A small, privately held operator, Dakota, Minnesota & Eastern Railroad Corp., wants to build competing tracks, but faces local opposition and funding problems.)

Lacking competition on this key route, Burlington Northern and Union Pacific have enviable pricing power. Hodges believes that both operators will be able to raise rates as they renegotiate their delivery contracts over the next several years.

Last year, Union Pacific shipped a record 194 million tons of Powder River coal, up nearly 8.4 percent from 2005. In the December quarter Burlington Northern's total coal shipment revenues soared by 22 percent to $775 million. Hodges expects the rail giants to grow their coal revenue at an 8 to 9 percent clip over the next three years, even though utilities have recently built up their coal inventories.

Hodges says they will also benefit from surging ethanol demand and the transport of goods from Asia. He has been buying shares of Burlington Northern since July 2004. Based on an average cost of $59.54, his stake was up 33 percent as of February 27. Hodges began building his holding in Union Pacific in March 2006; his shares were up 6.5 percent.

Rail operators aren't the only way to play rising demand for coal. With trains growing longer and shipments swelling, the need for railcars is also surging. "The average railcar is 25 years old. That's very old," says Hodges, who began buying shares of Dallas-based railcar maker Trinity Industries in September 2005. At the recent price of $42, his stake -- worth $15.8 million -- was up 28 percent.

Los Angeles­based First Pacific Advisors, which manages more than $10 billion, holds 3.8 million shares of Trinity in institutional accounts and the $2.2-billion-in assets FPA Capital Fund. Co-portfolio manager Rikard Ekstrand says that the company's orders in the December quarter grew 50 percent faster than sales. "Replacement demand is going to be higher over the next ten years than over the previous 20 years," he says.

Ekstrand points out one more reason to own the stock: Trinity makes railcars designed to haul ethanol, which absorbs water and impurities and can't be shipped by pipeline. "The company is going to be the largest railcar beneficiary in the U.S.," he says. Trinity will earn "north of $3" a share in 2007, Ekstrand figures, up at least 20 percent from his estimate of earnings per share for 2006 -- when the stock returned 20.5 percent.