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Play the lottery with airline, tech stocks
Technically, shares of Delta and Northwest are worthless -- but hope of a jackpot keeps some investors buying. That same mentality could fuel the next tech rallies.
By Jim Jubak
What do airline and technology stocks have in common?
Shares in both sectors trade puzzlingly above their fundamental value. Understanding why they do will tell you how to profit -- and how to keep the profits -- from the traditional post-Labor Day rally (if it materializes) and from a stronger and longer-lasting end-of-the-year technology rally.
The puzzle isn't exactly the same -- certainly not in degree -- for both sectors.
Most airline stocks, considering the industry's history of red ink and the likelihood that those flows of red ink will continue as far as the eye can see, should sell on their fundamentals -- for something close to zero. That's according to Martin Fridson's calculations in the Aug. 11 issue of his Distressed Debt Investor newsletter. (Go to www.Fridsonvision.com to see a sample, sign up for a free trial, or to subscribe.)
With airlines such as Delta Air Lines (DAL, news, msgs) and Northwest Airlines (NWAC, news, msgs) almost certainly headed for bankruptcy, which will wipe out the value of the existing common stock, Fridson says the puzzle isn't why the shares sell for $1.32 and $5.23, respectively, but why they sell for anything at all.
Most technology stocks are worth something based on their fundamentals. Here the puzzle is the persistence of valuations -- five years plus after the technology-stock bubble burst in 2000 -- that are much higher than current rates of sales and earnings growth justify. It's one thing for a Cisco Systems (CSCO, news, msgs) to trade at 16.9 times projected earnings on a projected earnings-growth rate of 12.1%. That's well within the parameters set by a consumer blue chip like Pepsico (PEP, news, msgs). But the 32.3 forward P/E ratio for Broadcom (BRCM, news, msgs) on projected 7.1% earnings growth and the 34.8 forward P/E for Qualcomm (QCOM, news, msgs) on projected 5.5% growth seem, well, curiously high.
Related news and commentary on MSN Money
Fridson, for my money the best analyst of high-yield bonds on or off Wall Street, offers a convincing explanation in his article for why airline stocks don't sell for $0.
What puzzles Fridson is the persistent underperformance of airline bonds and stocks. Since 1996, airline high-yield bonds have returned an average annualized 1.45%. That's stunning, since the average high-yield bond, measured by the Merrill Lynch High Yield Distressed Index, returned 7.19% a year. In other words, despite everything that investors know about airlines and their history -- the industry accounts for 12% of the 50 largest bankruptcies since 1970, for example -- investors have consistently paid too much for the industry's bonds.
A 20-year tailspin
The record on the stock side isn't any better. An investor who bought Delta's shares 20 years ago is today looking at a 92% loss. Northwest? An 86% loss over 20 years. AMR (AMR, news, msgs), the parent of American Airlines, shows what are comparatively stellar returns -- a 34% positive return over 20 years. But that's if you compare the stock to other airline shares and not to the Standard & Poor's 500-stock index ($INX, news, msgs), which has returned 543% in that time.
The persistence of such underperformance is simply extraordinary, according to conventional financial theory. Investors certainly know these companies have earned and will earn below-average profits. The theory says they should adjust the price they're willing to pay for the industry's bonds and stocks. Rational investors, Fridson summarizes, would look at each company's very low future cash flows, discount those to a present value and then pay a low price for the shares. That price should reflect that dismal financial performance, giving the investor a chance to earn a decent return. Buying a stock at $12 a share results in a loss if it drops to $6. But buy that same stock at $4 and you've got a profit.
So why hasn't this rational process driven down the price of airline securities?
The lottery-ticket mentality
Volatility is Fridson's answer. Conventional financial theory says that a rational investor will demand a risk premium before buying a bond or stock with greater-than-average price volatility. If the price of the bond or stock is more likely to go down than is the average stock, an investor would look to pay less to make up for the greater risk.
But Fridson points out that some parts of the financial markets aren't dominated by rational investors and conventional financial theory. Instead they're dominated by traders and speculators who follow what Fridson calls the lottery-ticket mentality.
In these parts of the market, traders buy shares with no expectation of holding for any length of time. Fundamental analysis and future cash flows are completely irrelevant. In these parts of the financial markets, volatility, rather than being a bad thing, is exactly what the investor is looking for.
Everyone knows that playing one of the state-run lotteries is a losing proposition. A typical payout, Fridson calculates, puts the fundamental value of each $1 ticket at about 60 cents. From a fundamental perspective, buying a lottery ticket is a way to guarantee a loss.
But fundamentals aren't important to lottery players. They buy a ticket despite the guarantee of a 40% loss -- fundamentally speaking -- because of the potential to turn $1 into $1 million. The size of the potential payout overwhelms the fundamental loss.
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