Investing in Airline Stocks

Airlines are an important part of the economy, but for much of their history, the stocks have been lousy investments. Airlines move with economic cycles, and past downturns caused multiple airline bankruptcies and failures. But in recent years, a series of mergers have created a smaller group of competitors more effectively using technology to manage schedules and set fares. Today four airlines control about 80% of the U.S. market.

Airlines in the U.S. fall into three categories:

• Full-service companies, which fly internationally, have different cabin classes, and serve many markets.
• Discounters, which offer fewer frills and fewer destinations.
• Regionals, which provide small-jet service to secondary markets under the brands of full-service partners.

Investors must understand several airline-specific terms and risk factors before they consider buying in. Here's what you need to know about investing in airlines and how to pick the stocks to buy.

The best airline stocks

There are about a dozen publicly traded airlines in the United States. Here are some of the most important companies to know:

• Delta Air Lines (NYSE:DAL) is the driving force behind much of the recent innovation in the industry. It kicked off a round of consolidation that helped stabilize the business when it acquired Northwest Airlines in 2008, and in years since it has revamped pricing to better compete with discounters. Delta even bought an oil refinery to help ensure jet fuel supplies. Buying Delta also provides some international exposure, as the airline owns stakes in airlines in Mexico, China, the United Kingdom, and Brazil.
• American Airlines Group (NASDAQ:AAL) is one of the oldest names in aviation, and for much of its history it was known as the premium flying brand. After a merger with US Airways, the airline now has more of a discounter mindset, but it still operates a massive network and has strong ties with leading European airlines.
• United Airlines Holdings (NASDAQ:UAL) has large operations catering to Silicon Valley and the energy sector, as well as a massive network throughout Asia. Those assets are all exposed to highly cyclical markets, and United's results can ebb and flow with tech or energy.
• Southwest Airlines (NYSE:LUV) is the original discounter, so successful in its early days of entering markets and bringing down prices that regulators dubbed that the "Southwest Effect." The airline is no longer an upstart, but it remains the only major carrier never to land in bankruptcy court, and its simplified operations have a track record of remaining profitable even when rivals struggle.
• If you are bullish on airlines but would rather not choose among individual companies, lower-risk investments like exchange-traded funds (ETFs) also cover the sector. U.S. Global Jets (NYSEMKT:JETS) is focused specifically on airlines, while iShares Transportation (NYSEMKT:IYT) and SPDR S&P Transportation (NYSEMKT:XTN) each count airlines as more than 25% of their holdings.

Key terms airline investors need to know

First-time investors in airlines will encounter terms and jargon unique to the sector:

RASM

Short for revenue per available seat mile, RASM is an airline’s total revenue divided by the number of seats an airline made available for sale, then multiplied by the number of miles an airline's jets flew. A plane with 100 seats flying 500 miles would generate 50,000 available seat miles.

This is important because international flights have a much different fare and cost structure from domestic flights, and different airplanes have different operating expenses. Simply looking at total revenue or expenses can’t give you the full picture. If Foolish Airlines, for example, flew 200 billion available seat miles in a year and reported total revenue of $30 billion, its RASM would be $0.15. That would be good: In recent years, the industry has posted an average RASM of just under $0.12.

RASM and its cousin CASM (explained below) are the most important numbers investors can look to when deciding between airlines. The figure helps to distinguish an airline that is selling tickets at any price just to fill its seats from one that has enough pricing power to sell seats at a price that covers its costs. Two different airlines could both have full airplanes, but as an investor, you want to focus on the one able to do it with strong margins.

CASM

Short for costs per available seat mile, CASM is an airline’s total costs divided by number of available seats, then multiplied by miles flown. It measures expenses the way RASM measures sales. If Foolish Airlines had total expenses of $24 billion during that year mentioned above, its CASM would be $0.12.

Load factor

Load factor measures how well an airline is filling its seats. For an individual flight, it is as simple as saying 60 of 79 seats were full. But for a major airline, that simple definition doesn’t tell the full story, because of differences in flight times. Airlines calculate their systemwide load factor by measuring how many seats were filled for each mile flown. Major airlines will provide this information on earnings releases and conference calls, but investors can calculate it at home by dividing revenue passenger miles -- as mentioned above, the number of passengers on a flight times the number of miles flown -- by the available seat miles.