They are the behemoths of the equity investment world. Fuelled by a surging stock market, growing retail interest in equities, and a shift towards self-directed retirement plans, America's mutual funds have been expanding at a breakneck pace. In less than two years, the total value of domestic equities managed by US mutual funds has almost doubled, from $704.5 billion at the end of 1994 to approximately $1,400 billion as of 31 October 1996, according to the Investment Company Institute, a trade association. The sum rises to $1,650 billion when foreign stocks held by these funds are included. Mutual funds also hold hundreds of billions of dollars in bonds, US Treasury securities, and money market instruments.
It is not surprising that the presence of mutual funds (which are similar to the unit and investment trusts that are sold to retail investors elsewhere in the world) looms large in the airline industry. Boston-based Fidelity Investments, the giant of its field with $434.9 billion under management, held over 5 per cent of the stock of 11 quoted US carriers last year. At various times during the past couple of years, Fidelity also amassed substantial stakes in seven others but subsequently reduced them again.
Last year, American Airlines parent AMR and Southwest Airlines were the only large US airlines which did not list at least one mutual fund company as the holder of more than 5 per cent of their shares. (Tiger Management, one of the largest US hedge funds, reported a 5.2 per cent stake in AMR. Southwest had no substantial shareholders, although Alliance Capital Management had a sizeable position in 1995.) Even Great lakes, a small regional, found that the Kaufmann Fund of New York had acquired over 10 per cent of its shares.
Many US fund groups have purchased shares in foreign carriers, but apart from KLM and British Airways, which have long been listed on the New York Stock Exchange, the level of activity remains quite low. 'It's very much in a beginning phase,' says Kevin Murphy, airline analyst at Morgan Stanley. One veteran analyst has seen an increase in the attention paid to Lufthansa, but adds that interest in Cathay Pacific and Singapore Airlines has dipped a little during the past year.
The large investments in US carriers can be viewed as just another manifestation of the clout of the mutual funds in the equity markets. The Investment Company Institute calculates that the mutual funds' holdings amounted to 13 per cent of the value of all US shares at the end of 1995. But the impact on airlines of the mutual funds in general, and of certain mutual funds in particular, is magnified by three factors.
To begin, airlines constitute only a very small sector of the US equity universe. Based on 13 December closing prices, the market capitalisation of all quoted US airline shares totalled $38.16 billion (not including convertible securities and the shares of non-US carriers like BA and KLM ). By contrast, the market capitalisation of General Electric alone amounted to nearly $155 billion, and the value of Merck's shares added up to almost $94 billion.
The market capitalisation of individual airline issues ranged from CCAir's $13 million to AMR's $8 billion. Consequently, it is not hard for even a medium-sized fund manager such as Portland, Oregon-based Crabbe Huson (with just over $4 billion under management) to accumulate major positions in the likes of Alaska Airlines and Airborne Express (which had market capitalisations of $329 million and $468 million, respectively).
Second, many other institutional investors have tended to avoid airline stocks. A substantial number of institutions prefer (or are required) to buy shares that pay a dividend. Since most US carriers do not offer a current return, they are automatically eliminated from consideration.
The greater volatility of airline equities and the sector's complexity also deter large segments of the investment community. In particular, these characteristics discourage commitments by insurance companies, which focus on stable, dividend-paying equities.
On the other hand, Nancy Gore, who heads the investor relations effort at America West, notes that hedge funds are often receptive to airline shares. She observes that these entities (which raise money from wealthy individuals and other institutions, and are not available to the general public) can take greater risks, and frequently seek out value situations. Airlines tend to trade at low multiples to earnings and cash flow.
Finally, among mutual funds, investment in airline equities is fairly concentrated within certain fund groups, while others have been much less active. For example, Capital Research & Management, with $178.5 billion under management, held over 5 per cent of Delta Air Lines and Federal Express last year, and formerly also had large positions in AMR, Alaska Air Group and Tower Air. But the Putnam Funds ($121 billion) and Franklin Templeton ($115 billion) reported no airline holdings in excess of 5 per cent. Gore says that analysts have told her that the same portfolio managers invest in airline equities over and over again. There are not many new entrants to the field.
'The airlines have traditionally been a more concentrated holding,' comments an analyst at a major Wall Street firm. Gary Kelly, chief financial officer at Southwest, says that although there are changes within individual funds, in general he sees the same names on his shareholder list year in and year out. In the early 1990s, when Southwest's earnings were expanding rapidly, the airline attracted a lot of 'momentum investors'. They are not in the stock now, but Kelly believes they may return when Southwest's growth picks up again.
'The knowledge base is not evenly distributed,' explains Murphy of Morgan Stanley. Not every fund group has an airline analyst, but Fidelity does. 'They have a lot of airline expertise. You have to understand the industry to make the investment. As one institution put it, "Airlines represent one-half of one per cent of the S&P 500 but 10 per cent of the work." ' Some institutions cannot justify the effort.
Another analyst says that certain investors have consistently made money over the years in airline stocks. Of those portfolio managers who allocate money to airline equities, 'I'd say maybe 20 per cent are traders and they know it. Another 20 per cent are long-term investors. They're willing to put up with a 30-40 per cent drop in a share price. The remaining 60 per cent start out as long-term investors but become short-term after they suffer their first 30-40 per cent loss.' Some of these investors swear off airline equities after they take a big hit.
This analyst has discerned a modest broadening of interest among institutions recently, but adds that many managers remain to be convinced. He maintains that evidence of the caution with which investors continue to regard airlines is provided by the industry's price-to-cash flow ratio, which represents the best long-term valuation measure. Price:book ratios are meaningless, and the industry has not had enough profitable years for there to be a good historical record of price:earnings multiples.
From 1983 to1995, the US airline sector as a whole traded at an average of 4.6 times cash flow. During this period, the airline industry price:cash flow ratio averaged 57 per cent of that for the S&P 500 as a whole, but by the end of 1996 the airlines' performance by this measure had dropped to 27 per cent.
The head of investor relations at one major US carrier says that airlines probably attracted more attention last year than in 1995, because of the industry's improved performance. The level of interest is cyclical; it was quite strong in the late 1980s when carriers were performing relatively well, too. Gore at America West comments that mutual fund managers are influenced both by industry-specific developments, such as the lapse of the excise tax and the slowing of capacity growth, and by macro factors. One element in the equation is how much fund managers want to allocate to cyclical equities like airlines.
Those funds that accumulate large holding can have a dramatic influence on airline stock prices. One investor relations official observes that even those portfolio managers that take a longer-term approach tend to trade in and out to some extent. If they do not sell their entire position, they may reduce it sharply from time to time. During the second week of December, UAL's share price increased by 11 per cent; heavy purchases by a few big buyers were thought to be responsible.
Mutual funds often play a key role in the success of airline equity offerings. They also have participated in private placements. Fidelity invested in the transaction that took America West out of bankruptcy and in a private placement of convertible preferred stock for Reno Air. Kevin Richardson, who acts as Fidelity's US airline analyst and as the manager of the firm's Select Air Transportation Portfolio, says that he uses the same techniques to analyse a private placement opportunity, but he demands a higher return because of the greater risk caused by the illiquidity of the investment. He is not, however, receptive to startups. 'I'm not a venture capitalist,' he says.
When it comes to corporate governance disputes, the mutual fund groups have not been as active as certain other US institutional investors, such as pension funds and private investment partnerships. 'We're not really out to tell people how to run their business,' says Mason Cole, director of communications at Crabbe Huson. A Fidelity spokesperson says that although the legendary Peter Lynch, who ran Fidelity's Magellan Fund for many years, joined a few boards after he stepped down from active fund management, portfolio managers may not take board seats.
Fund groups do, however, vote on issues presented to the shareholders. Rex Sinquefield, co-chairman and chief investment officer of Dimensional Fund Advisors (which currently owns over 5 per cent of both Amtran and Tower Air), says that his firm always votes the proxies it receives. 'We will only assume an active role if there is an important proxy issue,' he adds. 'We will take a close look at anything out of the ordinary on a proxy.' Sinquefield says that DFA's vote played an important role in approving the transaction in which an investor group led by Peter Ueberroth acquired a majority interest in Hawaiian Airlines. DFA voted in favour because it did not see an alternative, Sinquefield says.
The different fund groups depend upon a wide variety of techniques and philosophies to evaluate investments. Jane Okun, director of investor relations at Northwest Airlines, says that some investors don't even want to talk to the companies in their portfolios; they rely on models which tell them when to buy and sell. DFA manages about $19 billion, with $9 billion in mutual funds and the rest in group trust for pension plans. It runs index funds, including small capitalisation index funds and value funds, which seek to identify companies with low book:price ratios. DFA is prepared to buy stock in every company that falls within the criteria established for the fund. Consequently, its funds own shares in 26 different categories. 'All these companies hire investor relations firms and think they can talk up the price of their stock. They can't,' Sinquefield declares.
Fidelity and Alliance (which had $174 billion under management in early December) employ airline analysts who act as resource people for the rest of the firm. In addition to Richardson, Fidelity has analysts in London and Tokyo, as well as Eric Lass in Boston, who specialises in airline debt. Tice explains that Fidelity's large positions are the sum of a series of decisions taken by individual portfolio managers. There are no committees or senior managers who make macro decisions for all the funds. One portfolio manager may be selling an issue which another is buying.
Similarly, an Alliance spokesman says: 'It's rare that the firm as a whole will say, "This is a good industry to be in." ' It is more likely that a portfolio manager will come up with an idea and will consult with the appropriate analyst, or that an analyst will make recommendations to those portfolio managers for which it is suitable. At both firms, analysts are the primary point of contact with airlines, but portfolio managers regularly join conference calls and meetings with management.
Because of the proliferation of funds that specialise in small-capitalisation equities or in particular industries, even the largest fund groups may consider investments in small companies. Richardson follows every US airline, and he has written a note on a carrier with a market capitalisation of only $14 million.
Some airlines take a more aggressive stance in investor relations than others. Cliff Hew, United's director of investor relations, says the carrier participates in many airline equities conferences organised by the "sell-side" (brokerage firms) and has accompanied sell-side analysts on visits to their major accounts, but has not initiated many meetings with investors directly. This policy may change, however. 'To attract the attention of investor groups, you really have to get out there,' advises America West's Gore. Gary Kelly at Southwest says management travels to New York, Boston, San Francisco, Minneapolis, Kansas City, and Houston annually to meet fund groups. He notes that while sell-side conferences are useful in reaching portfolio managers who are already active in airline equities, they are not as effective in contacting 'non-traditional' investors.
One analyst gives this advice to airlines: 'By far the most effective thing is to have an outstanding investor relations function. I'm talking about an all-encompassing IR function that is open.' He believes that AMR's efforts stand out. 'They give you all the information you need. They long ago realised a fundamental fact of the investment business. Sell-side analysts who can move the price of the stock spend 10-20 per cent of their time doing fundamental research. That is because these analysts are beholden to investment banking departments, the institutional sales forces, big retail producers, and other areas of their firms. Consequently, American concluded that if they want analysts to know the company well, they have to do as much of their job for them as possible.
Source: Airline Business
