Airline Investors Don't Know What's Good for Them

Most airline stocks have underperformed the market this year, even as the airlines have been posting record profits. The cause of airline stocks' woes was encapsulated in the responses to a recent question posed by Morgan Stanley to investors (i.e., its clients).

The analysts asked the following question: "What do you prefer: (A) low oil, limited capacity discipline, and higher profits, or (B) high oil, increased capacity discipline, and lower profits?" More than three-quarters of respondents picked option B.

This decision is completely irrational. Frankly, it shows that airline investors don't know what's good for them. Investors should want any company they invest in to maximize profit and grow over the long run. This irrationality is a key reason long-term-oriented investors continue to have great investment opportunities in the airline sector.

A sad but unsurprising resultWhile it's unfortunate that so many investors still get distracted by factors other than long-term profit growth, the survey results weren't a big shock. Airline analyst Jamie Baker commented a few months ago that he was getting constant calls from investors about his unit revenue expectations, but not one question about his (bullish) profit margin and cash flow projections.

Meanwhile, another analyst had foreshadowed these survey results in May, when he said that investors should "pray for higher oil" -- even though that would lead to lower earnings -- because it would encourage the airlines to halt their growth and raise fares.

JetBlue Airways has been by far the best-performing U.S. airline stock this year for a similar reason: It has been the only airline to keep growing unit revenue consistently.

Airline YTD share performance, data by YCharts

While shares of Delta Air Lines , American Airlines , and United Continental have all declined year to date, JetBlue stock is up nearly 50%. Delta, American, and United are all posting strong earnings growth this year, but they're being punished for mid-high-single-digit unit revenue declines that haven't moderated yet.

The idea behind this misguided notionAs is often the case, there is a nugget of insight behind airline investors' irrational obsession with unit revenue growth and capacity discipline over profit.

These investors probably reason that the current cheap oil environment won't last forever. If oil prices start to rise again and unit revenue doesn't follow in a hurry, the airlines' profitability could collapse again. And the more capacity that airlines deploy, the harder it will be for them to raise fares. So these investors would prefer that oil prices had remained high all along.

However, all three big legacy carriers -- Delta Air Lines, American Airlines, and United Continental -- have shown in the past that they can move quickly to pare back capacity and raise fares when conditions warrant it.

In the present low-fuel-cost environment, they don't need to -- they are all earning record profits despite falling unit revenue. In fact, cutting capacity would be self-defeating. Smaller carriers including JetBlue are already growing rapidly. More "capacity discipline" by the legacy carriers would just create even bigger opportunities for these upstarts, encouraging them to grow faster.

In the long run, the total amount of industry capacity might not be all that different. But it would be a much more fragmented industry. That would be even worse for airline stocks.

What it means for investorsIn the short run, just about anything can affect stock prices. In this case, it appears that unit revenue is the key metric determining airline stocks' fates, driving JetBlue shares higher while sinking shares of Delta, American, and United.

In the long run, it's all about earnings. There's no good reason for investors to prefer a high-fuel economic climate where airlines are earning less money now, because that wouldn't necessarily lead to better earnings further down the road.

Savvy long-term investors can potentially profit from this widespread irrational behavior by investing in legacy carrier stocks, which are all extremely cheap, with single-digit earnings multiples. In the long run, as long as their profits remain stable or growing, investors will be well rewarded, regardless of what happens in between.

Furthermore, Delta, American, and United are all buying back lots of stock to take advantage of their artificially depressed stock prices. Delta announced a new $5 billion buyback in May, and United just added $3 billion to its buyback plan on Thursday. Not to be left out, American Airlines doubled its repurchase plan to $4 billion on Friday.

The longer their stock prices stay depressed while profits stay high, the more shares Delta, American, and United will be able to repurchase. That means greater long-term EPS growth. And in the long run, that will lead to superior results for long-term investors.

The article Airline Investors Don't Know What's Good for Them originally appeared on Fool.com.

Adam Levine-Weinberg owns shares of United Continental Holdings, and is long January 2017 $17 calls on JetBlue Airways, long November 2015 $40 calls on American Airlines Group, and long January 2017 $40 calls on Delta Air Lines, The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.