Falling oil prices have made air travel attractive again, with an estimated 6 million Americans expected to fly sometime over the holiday season. If growth in jobs and the economy continues, more people could go traveling, a boon to stocks of airlines and hotels.
None other than Warren Buffett, the billionaire investor who swore off airline stocks as "a bottomless pit" after getting burned on a stake in U.S. Air in the late 1980s, has caught on to the possibility.
Berkshire Hathaway (BRK.A) , (BRK.B) watchers were surprised to see airlines show up on the quarterly list of holdings the company reported in November. For years, Buffett has hated airlines. He was ultimately able to unload his U.S. Air position a decade later at a profit, but he described his dabbling in the sector as "foolishness" in a letter to Berkshire Hathaway shareholders many years later.
The industry, he said, didn't match his investment criteria. Airlines' insatiable demand for capital made them a poor choice. They are highly cyclical companies, prone to economic downturns and vulnerable to swings in energy prices. They seemingly go bust and merge all the time.
What has changed this time? The stakes are inevitably the brainstorm of his two lieutenants who are being groomed to take over some day, but shares of Buffett's target companies, American Airlines (AAL) , Delta Air Lines (DAL) , United Continental Holdings (UAL) and Southwest Airlines (LUV) , are trading at low price-to-earnings ratios that make them value plays.
This may not be the industry it was in the 1980s and 90s. Airlines are benefiting from low fuel costs since the drop in oil from over $100 a barrel just a few years ago. With $50 a barrel oil, shale drilling and the embrace of alternative and clean energy, there doesn't seem to be an impetus to increase prices any time soon.
If this oil price is the new normal, airline investors could see both growth in earnings per share and gains in dividend payouts.
Delta Air Lines has a return on equity (ROE) of 8.2 and the company boosted its quarterly payout to shareholders to more than $0.20 from $0.135 earlier this year. Alaska Air Group (ALK) has an ROE of 12.8 and a payout of $0.275 a quarter. American Airlines has a 5.3 ROE and just announced a $0.10-a-quarter dividend.
All three of these stocks get strong scores based on the strategy that emulates the investor Joel Greenblatt. In his best-selling book, The Little Book that Beats the Market, Greenblatt developed a relative simple, yet powerful, quantitative value investing model. His "magic formula" examines a stock's earnings yield and also the return a company generates on its capital.
Earnings yield takes the price-to-earnings ratio and inverts it, adding the company's debt to the denominator. This effectively tells you the return you would receive if the company paid out all its earnings as a dividend. Return on capital is derived by dividing earnings before interest and taxes by the sum of net working capital and fixed assets. The strategy culminates by averaging these two measures and looking for those stocks that get the highest combined ranking.
The table below shows how each of these airlines mentioned above stack up based on my modeling of Greenblatt's formula.
These companies have been turning out record profits because of the decline of oil prices that has eased margins. Meanwhile. they continue to have a strong grip on pricing after unbundling services such as carry-on baggage storage and premium seating. It remains to be seen if they can hold on in the face of competition from bargain carriers, but Buffett has shown a penchant for picking companies with staying power.