Why I'm Investing in Airline Stocks

"Fasten your seat belts. It's going to be a bumpy night," said Bette Davis in All About Eve, the classic 1950 film about the theater. I think I know what she meant. As a new investor in the airline industry, I am prepared for turbulence.

See Also: Annoying Companies, Great Stocks

And abuse. After all, I have just violated the most sacred of Warren Buffett's rules, the one that says you should never invest in anything that flies. Or as the master put it: "The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down."

As a newly minted member of the Spare Orville Club, I acknowledge that the business was awful in 1989, when Mr. Buffett invested in USAir. But it really is different now. Consolidation and bankruptcies have transformed the U.S. airline industry into exactly the kind of business that Buffett likes: an oligopoly. After US Airways completes its acquisition of American Airlines, three carriers--Delta Air Lines (symbol DAL , $18), United Continental ( UAL , $33) and US Airways ( LCC , $17)--will control 70% of the U.S. airline business (prices are as of May 3).

These three have been making money for the past three years and may achieve record profits in 2013. Some wise investors have noticed. At the end of 2012, David Tepper, of Appaloosa Management, had huge positions in each of the three stocks, and George Soros owned two of them.

If you didn't know their past and just looked at the numbers, you'd find airlines appetizing. Alas, they make many investors reach for an airsickness bag. Most pros consider the industry untouchable because the airlines have historically operated irration­ally and have always been at the mercy of oil prices, unions and new competition.

All of those past problems spell opportunity, and that's why Delta, United and US Airways now account for 7.5% of my hedge fund. Airline analyst Helane Becker, of Cowen Securities, sums up the bullish case when she cites the "four C's" that should propel industry returns: Consolidation, Capacity discipline, Charging for everything and returning Capital to shareholders.

Becker doubts many investors know that Delta is more profitable than FedEx. Delta's operating profit margin (profits from operations divided by revenues) is 10%, or twice that of FedEx. Becker estimates that Delta will generate $1 billion in free cash flow (the money left for dividends, buybacks and acquisitions) in 2013; she forecasts $400 million for the much larger FedEx.

Bargain Prices

If you think all of this is reflected in price-earnings ratios, you're wrong. FedEx trades at 13 times estimated 2014 earnings, Delta at just 6 times 2014 estimates. United and US Airways are also tantalizingly cheap, and Becker says US Airways shares could rise dramatically after its merger with American becomes effective.

Interestingly, some investment shops ignored their own quantitative models because airlines seemed so toxic. "Our data said the group was attractive in March 2012," says Leuthold Weeden analyst Kristen Hendrickson, "but we didn't buy until last November. We were still a little skeptical of the group. Today we rank it fourth out of 120 groups on attractiveness."

Clark Hodges, of Hodges Capital, says airlines remind him of the railroads. "For 20 to 25 years, the railroads didn't earn their cost of capital. Then things gradually changed, and Burlington Northern became our largest holding. And then Warren Buffett bought Burlington Northern." Will Buffett swoop in to snatch an airline out of the sky? Probably not. But maybe he should.

Columnist Andrew Feinberg manages a New York City-based hedge fund called CJA Partners.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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