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Old 09-04-2005, 02:38 AM   #1  
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Default Lottery w/airline stocks

Jubak Journal

Playing the Lottery With Airlines and Tech
By Jim Jubak
MSN Money Markets Editor
9/1/2005 7:22 AM EDT

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 usual 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.

With airlines such as Delta Air Lines (DAL:NYSE) and Northwest Airlines (NWAC:Nasdaq) almost certainly headed for bankruptcy, which would 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 on the basis of 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:Nasdaq) 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 such as PepsiCo (PEP:NYSE) . But the 32.3 forward P/E ratio for Broadcom (BRCM:Nasdaq) on projected 7.1% earnings growth and the 34.8 forward P/E for Qualcomm (QCOM:Nasdaq) on projected 5.5% growth seem, well, curiously high.

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:NYSE) , 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 with other airline shares and not with the Standard & Poor's 500 stock index, 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.
Infinitely Attractive, and Worthless
The traders who bet on airline bonds and stocks find them attractive not as fundamental investments but as lottery tickets. Delta's shares have produced monthly returns of 9% or better in 56 of the past 300 months, according to Fridson. That positive monthly return annualizes out to a better than 180% total return. In one case, the monthly return exceeded 40%.

For long-term investors, these numbers don't matter much: Over those 25 years, Delta's return is deeply negative. But to lottery players, they do matter.

Nor is Delta a unique case. AMR's stock shows 42 monthly returns of 12.8% or better and two occasions when the one-month return exceeded 38.8%.

With that kind of lottery potential, who cares that these bonds and stocks are guaranteed fundamental losers over the long haul?

And, perversely, since the potential for a lottery ticket paying off huge rises as the price of the stock falls, investor betting works to support the price of airline bonds or shares on the downside. The stock never falls to $0, because at $0, the potential return from winning the monthly lottery is infinite.

I find Fridson's logic attractive, and I think it has application to sectors besides airlines, including sectors in which the stocks have much greater long-term fundamental value than airline stocks do.

The Next Tech Rally
I think the prevalence of lottery-ticket investors in the technology sector has three implications for investors.

First, I think that technology-sector rallies -- for example, the typical end-of-the-year rally that begins in late October -- are likely to be short and very sharp. Lottery-ticket investors jump in at the first sign of a rally in order to put themselves in a position to win a big jackpot while lottery tickets are cheap -- and they then jump out at the first sign that momentum is fading. Since these investors aren't paying any attention to fundamental valuations to begin with, they can't be kept in the market by analysts who try in the later stages of rallies to argue that valuations are still reasonable. There's no point to holding a lottery ticket once you have the opportunity to cash out.

Second, I think any technology-sector rallies the rest of this year will be led by lower-priced, more speculative and more volatile stocks -- as was the case in 2004. The logic of lottery-ticket investing tells you to buy cheap tickets. They'll go up more on a percentage basis, if they do go up, and they'll cost you less on an absolute dollar basis if they crater. So lottery-ticket buying tends to concentrate on high-beta, small-capitalization stocks with easily understood and easily promoted stories. Sure, the technology stocks with reasonable fundamentals will go up in any rally, but don't expect to see Microsoft or Cisco lead the pack.

And, third, I think it makes sticking to your discipline, whether it's fundamental or lottery, absolutely essential. In a normal market, value investors buy first and then sell to growth investors, who sell to momentum investors. Forget about that pattern in a lottery-ticket market. Here, the momentum investors begin the rally and hope that growth investors will get sucked into the excitement before the upward momentum shifts.

You don't want to be the fundamental investor who forgets those fundamentals just in time to be the last buyer. Nor do you want to be the lottery-ticket, momentum investor who forgets his discipline and convinces himself that the stocks that have been rising so fast and furiously must have solid fundamentals after all.

Take a tip in any technology rally from all those temporary rallies in airline stocks that have punctuated the long downturn in the sector -- a 9%, a 13% or even a 40% monthly gain in a lottery stock isn't a sign that the fundamental story has changed for the better. Gains like that are more often a sign that it's time to sell.

And now, of course, all we need is a thrilling, if temporary, post-Labor Day rally so that we can test all this theory.
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