Big Airline, Small-Cap Fund: Why Hodges Capital Likes American Airlines

May 5 2014, 11:42am CDT | by

A small-cap growth fund may not seem the likeliest of homes for American Airlines Group, considering its $8 billion market cap, but for the $1.1 billion Hodges Small Cap Fund, American fits perfectly.

The investment in American illustrates the crux of the Hodges investment strategy – recently profiled in Forbes magazine – which seeks out businesses that are growing revenues and profits, without getting distracted by the headlines about the broader market’s performance or macroeconomic conditions.

Dallas-based Hodges didn’t actually buy American Airlines shares, it wound up in the stock through owning US Airways before the two carriers merged. The firm bought those shares at about $5.90 in the fall of 2011, but has reaped the benefit as the combined entity has rallied almost 50% since the two carriers closed their merger in late 2013.

(The fund is required to keep 80% of its assets in small caps, but American, even with its $26 billion market cap, doesn’t count toward that other 20%, grandfathered in because the position originated in small-cap US Air, until and unless the fund buys more of the stock.)

Craig Hodges, CEO and co-manager of the small-cap fund, is particularly proud of the airline bet, which has paid off handsomely to date and remains a significant part of the portfolio. American Airlines and Spirit Airlines ranked as the fund’s third and fourth-largest holdings as of March 31, at 3.5% and 2.7% of the portfolio respectively.

Hodges says the firm’s airline play echoes one it made in the railroad business just about a decade ago. That one was tipped off when his father Don, who recently turned 80 and has spent more than 50 years in the investing business, was reading the local paper from his boyhood hometown of Canadian, Texas.

Burlington Northern wanted to put in an overpass, because they were running a train through town every 18 minutes,” Don recalls, and he figured if the railroad was doing that much activity it was worth looking into. The firm bought its stake in Burlington after kicking the tires for a while, but didn’t own it for long as Warren Buffett came calling in 2009 with a Berkshire Hathaway takeover offer. The Hodges team didn’t fret though, plowing its haul from the takeover into another railroad, Kansas City Southern.

These days, the Hodges appetite for the railroads themselves has cooled a bit – it sold out of Kansas City Southern with huge profits – but it still has rail-related investments like Dallas-based railcar maker Trinity Industries and locomotive components outfit Wabtec.

Craig Hodges sees similar trends in the airlines, citing the relative limits of competition in an industry long-maligned as being unable to get its act together. He still thinks there’s ample flying time in the airlines themselves though, and isn’t yet turning focus to the so-called “downstream” players like parts makers.

That view comes even as the sector has posted mostly improved profits even in the face of severe winter weather that prompted tens of thousands of flight cancellations. (See “Airline Earnings Roundup.”)

Year-to-date, American is up 45%, Delta Air Lines 37%, Southwest Airlines 29% and United Continental Holdings 8%. JetBlue Airways has been left out of the rally, down 2% in 2014.

AAL data by YCharts

Hodges thinks American Airlines can earn more than $7.00 per share in 2015 (Wall Street consensus is $6.03 according to FactSet), making today’s $36.53 share price look reasonable even the rally to start 2014.

Hodges also owns Spirit Airlines, known for it’s a la carte pricing philosophy that includes a charge for everything from checking a bag to picking out seats in advance.

“It’s really for people trying to find a deal who do not want to check a bag,” says Hodges, and its focus on the leisure, cost-conscious traveler puts it on something of a different playing field.

Raymond James analyst Savi Syth agrees. Spirit and fellow small carrier Allegiant Travel are among her preferred picks in the space. “They’re matching revenues to costs,” she says, which sounds like common sense but is something of a revolution in the airline industry.

That goes all the way up to the biggest players, which for years would undercut each other on price, barely breaking even when times were good and falling to the brink of collapse when the economy turned sour. The legacy of an clumsy with only an arms-length relationship with profitability means there are many investors who won’t even consider buying the airlines.

“It may be that 95% of people who would never touch an airline stock, and the other 5% all have different opinions,” jokes Hodges./>/>

For her part, Syth says it’s still too early to tell whether a new group of investors are coming around on airlines.

“A lot of people still see it as a trading sector and have been taking profits during the current phase,” she says. “Some others are willing to stick it out longer term and there might be some that are starting to get interested, but remain hesitant.”

To really draw in the skeptics, the industry has to prove itself during the next downturn. “If airlines stick to capacity discipline when it gets tough and can at least break even, that would be good,” Syth says. By then of course, the early investors like Hodges may be long gone.

“There will come a time when the airlines are no longer attractive to us,” he says, “but we’re not there yet.”

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