Airlines squeeze passengers, score profits

By Jon Markman

Is there anything worse than air travel these days? Combine long lines, no meals, pitiful snacks, surly attendants, cramped seats, high prices, lousy movies and overbooked flights with bad weather and a smelly, overweight seatmate, and you've got just about the worst nightmare an already stressed-out business person can ever face.

And yet the airline industry -- which no one likes, and which has been the single worst investment in the stock market for decades -- has surprisingly been by far the single best performer in the stock market over the past six months. It may have quite a long way to run still. So much for the old adage about how you should invest in what you like.

The easy explanation for this paradox is that crude oil prices have dropped 35% since Aug. 1. Since jet fuel is one of the largest costs for the airline industry, surely airlines' earnings strength must simply be proportionate to the decline in expenses.

But easy explanations are seldom sufficient. You know that the decline in fuel costs can't be the whole story because an index tracking major airlines, such as AMR Corp. (AMR, news, msgs), which operates American Airlines, is up 65% since Aug. 1, or almost double the decline in oil prices.

For that matter, AMR and UAL (UAUA, news, msgs), which operates United Airlines, are themselves each up about 95% in the past six months -- tripling the return of more lavishly praised companies like Google (GOOG, news, msgs) and Apple (AAPL, news, msgs). Something else must be at work.

The answer, in part, is that Wall Street in recent years has tended to most reward companies from which the least is expected. And very, very little is expected from airlines.

Buffett's folly

Last year, according to a new study published by Birinyi Associates, the single best strategy that you could have pursued would have been to buy all companies at the start of the year with the lowest projected five-year growth rates. Weird, but true. Examples were stocks like AMR, which analysts expected to grow just 6% annually over the next five years. Its shares were up 36% in 2006. Contrast that with eBay (EBAY, news, msgs), which analysts expect to grow a robust 25% annually over the next five years. Its shares were down 30% in 2006.

So the remarkable thing about airlines last year, and which is still in force today, is that so little is expected of them from bitter consumers and long-abused shareholders that any good news at all is cause for celebration.

How bad have airlines been as an investment over the years? The Dow Jones Industrial Average ($INDU) is up almost 870% since 1985. The major airlines are up just 160% over the same span. Since 1995, the Dow is up 225% while the airlines are up just 25%.

Even Warren Buffett ran into trouble investing in airlines. He tried to make a value call on US Airways, then USAir, in the 1990s and imperiled as much as $350 million in shareholder money when it went bankrupt before ultimately hanging on and emerging with a slight profit. He reworked an old joke when issuing a mea culpa to his Berkshire Hathaway (BRK.A, news, msgs) investors over the fiasco:

"When Richard Branson, the wealthy owner of Virgin Atlantic Airways, was asked how to become a millionaire, he had a quick answer: There's really nothing to it. Start as a billionaire and then buy an airline."

• Video: Getting bumped off a flight
  

What's different now? Consolidation is a big part of it. Mergers have taken hundreds of planes off routes, making remaining seats more valuable. Yes, the fact that flights are more crowded and harder to find is what's making the industry more profitable. Throw in more rational pricing, falling debt levels, short covering and that whopping energy-cost decline, and you have everything required for a sustainable bull market. These stocks are going places.

Friendly stocks

To be sure, much of the secret sauce in airlines' success does stem from the energy rout. More precisely, it's a phenomenon that the investment community calls "operating leverage." That is the benefit a company receives from small changes to costs that are presumed to be fixed. Investors' profit-and-loss estimates for airlines going into 2006 were predicated on high fuel costs, for example. The change in those costs has been so extreme that they've had a disproportionate effect on earnings. They act as a lever propelling profits much higher than you might expect, just like a small person can send a large person flying if they're seated at opposite ends of a teeter-totter.

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