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david berman

Seven years after Warren Buffett paid $44-billion (U.S.) for Burlington Northern Santa Fe Corp. in late 2009, marking the biggest bet of his career, investors continue to see great opportunity in railway stocks.

But their optimism rests on ongoing efficiency gains and speculation that a round of consolidation is in the works, which makes these stocks look far less inviting.

Mr. Buffett struck his deal when U.S. railway stocks, like much of the rest of the market, looked neglected. The S&P 500 index of railway stocks traded at little more than 14 times trailing earnings.

The low valuation suggested Mr. Buffett saw an opportunity to buy an economic engine at a time when most other investors saw only lumbering locomotives pulling old coal hoppers.

Now, U.S. railway stocks trade near decade-highs of 22 times trailing earnings following a 57-per-cent rally over the past 12 months. The valuation of Canadian National Railway Co. and Canadian Pacific Railway Ltd. aren't far behind their U.S. peers.

To be fair, investors probably aren't copying Mr. Buffett's move at this point in the cycle. But they are piling on to a thesis that is looking increasingly stretched: that one particularly inspired chief executive officer can remake the North American railway sector. That CEO is Hunter Harrison, who most recently ran the show at CP. After the company reported its fourth-quarter financial results this week, it announced that Mr. Harrison was leaving his position five months ahead of schedule, setting off a flurry of speculation that he was moving to another railway.

The Wall Street Journal had a suspect: CSX Corp. It also had a backer: Paul Hilal, an activist investor who once worked for Bill Ackman, the hedge-fund manager who shook things up in recent years at CP under Mr. Harrison's leadership.

None of this been revealed officially yet. But that hasn't stopped investors from rushing into railways. CSX shares jumped 23 per cent on Thursday, presumably under the belief that North America's least-efficient carrier was about to get a work-over under Mr. Harrison.

Curiously, though, other railway stocks also rallied, including CP. This sector-wide move suggests that another dream is also driving the action: After years when regulators have looked at railway mergers unfavourably, perhaps regulators would now change their tune.

You can understand why railways might want to consolidate. While efficiency gains have helped drive profits higher, some of the underlying operations have been looking less inspiring.

At CP, freight revenues in 2016 fell 8 per cent from the previous year. Similarly, CSX reported that freight revenue fell 6 per cent in 2016, and its outlook for the first quarter showed that more than 70 per cent of its volume was expected to be either flat or down. CN will report its results on Tuesday.

Investors may be betting that a rebound in commodity prices will turn these figures around.

But the bigger opportunity by far is if sluggish operations help justify among regulators the need for consolidation. Some observers believe that mergers would not only make railways bigger, but also let them get through congested hubs a lot faster.

Under Mr. Harrison's leadership, CP had approached CSX and then Norfolk Southern Corp. as takeover candidates, but neither panned out and CP withdrew its bid for Norfolk Southern this past year.

But Mr. Harrison has not given up, and sounded defiant on the need for mergers and acquisitions activity in an interview with The Globe and Mail last year. His departure from CP has clearly raised hopes among investors that consolidation is back on the table.

Mr. Buffett has made a pile of money since buying BNSF when it was cheap. You have to wonder if he'd still be a buyer today.

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