The stocks of U.S. airline companies have enjoyed an impressive run so far this year. The New York Stock Exchange Arca Airline Index (INDEXNYSEGIS:XAL) was up about 12 percent year to date as of mid-October.
So does this make now a good time to invest in airline stocks? Maybe … and maybe not. To decide whether airline stocks should be a part of your portfolio, you need to look at the longer-term history of airline stocks and consider the inherent volatility of this industry.
Historically, airlines have been among the most volatile industries on Wall Street. This is due to several factors — primarily, airlines’ vulnerability to wild swings in fuel and labor costs and the fact that airlines’ fortunes are tied closely to the broad U.S. economy as a whole.
The impact of fuel prices and labor costs on airlines’ profitability is fairly obvious. The more airlines have to pay for fuel and in wages for employees, the less profitable they will be. Moreover, oil is one of the most volatile commodities there is — its price can rise and fall drastically based on world events and production output, among other factors.
According to one estimate, each one-dollar rise in the price of a barrel of oil costs the global airline business up to $1 billion. Airlines can lessen their exposure to fuel price volatility by purchasing oil futures that lock in oil prices for a certain number of years. However, not all airlines choose to do so.
In addition, airlines are very sensitive to the macro economy. When the economy is slow or in recession, people take fewer vacations and companies cut back on business travel. Conversely, when broad economic data like consumer spending and employment numbers start to rebound, airline performance and stocks often follow close behind.
At least one famously successful investor — Warren Buffett, aka the Oracle of Omaha [LINK] — avoids investing in airline stocks as a rule. This is mainly because airlines require a heavy upfront capital investment in order to grow quickly and operate on thin profit margins. Buffett went so far as to blame an investment he once made in US Airways on “temporary insanity” — even though he made money on the trade.
Here is how Buffett summarized his feeling about investing in airlines:
“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.”
Throughout history, bull runs in the airline industry have inevitably been followed by downturns that often wiped out investors’ gains. These downturns were usually caused by soaring oil prices, disputes with labor unions leading to higher wages, recessions or all of the above.
However, many airline stock bulls today believe that things have fundamentally changed in the industry in such a way that these boom and bust cycles are a thing of the past. They primarily attribute this to what one industry analyst recently referred to as the “4 C’s” of airline profitability: Consolidation, Capacity discipline, Charging for everything, and returning Capital to shareholders.
The U.S. airline industry has been steadily consolidating over many years, and now four major carriers — United, American, Delta and Southwest — control more than 80 percent of the domestic market. The reason for airline mergers and acquisitions is simple: It is more efficient for airlines to merge as a way to acquire new gates and routes and reduce labor costs than it is to try to do this on their own.
Meanwhile, most airlines have become more disciplined in recent years with regard to controlling capacity growth to keep it in line with demand from the flying public. In addition, if you have flown anytime recently, you know that nothing on a flight comes free anymore.
While Buffett’s rationale for avoiding airline stocks could be sound, his shunning of the industry as a whole from an investment perspective might be a little bit extreme. Airline stock bulls point to positive signs with regard to the 4 C’s as noted above, especially reduced competition due to the wave of industry consolidation.
Falling oil prices are another reason to consider feeling bullish about airline stocks. As of mid-October, the price of a barrel of Nymex Crude Oil had fallen by 15 percent since late June. While oil prices could suddenly spike again at almost any time, the signs right now are pointing toward lower oil prices in the near-term future.
If you do decide to add airline stocks to your portfolio, be prepared for a bumpy ride. There is no reason to believe that the volatility the airline industry is known for will smooth out much any time soon.