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Revisiting Our Hedges and Best Buys

By Peter Staas on Jul. 18, 2015

We added American Airlines (NSDQ: AAL) to the model Portfolio in January 2014 as a hedge against future weakness in crude-oil prices—at the time, we worried that growing US production could exacerbate the seasonal weakness that occurs when refineries close for maintenance and upgrades in the fall. (See Buy the Friendly Skies.)

American Airlines’ policy of not hedging its fuel exposure gives the company significant upside exposure to lower oil prices.

Our investment thesis also hinged on an improving supply-demand balance in the airline industry, as leisure and business travelers returned to the skies and industry consolidation helped to reduce capacity and improve operating discipline.

This hedge worked wonders for the Model Portfolio’s aggressive sleeve, with American Airlines’ shares rallying to a high of $56.20 in late January 2015—a gain of more than 100 percent.

However, the stock has pulled back by about 25 percent from this peak, reflecting a number of headwinds. Some of this downside stems from routine profit-taking after a huge run-up, fueled in part by the exodus of short-term investors that flooded into the position as a hedge.

At the same time, industry-wide capacity additions and intensifying price competition from discount operators have raised concerns that airlines have abandoned their recent discipline and returned to their old habits.

The US dollar’s recent strength, coupled with weak local economies, has also weighed on international demand, especially in Latin America.

And the Dept of Justice’s antitrust investigation into whether airlines colluded to control the supply of available seats in an effort to bolster prices has sparked a number of class-action lawsuits from consumer groups.

Despite a more challenging competitive environment and the aforementioned antitrust concerns, we continue to like our position in American Airlines as a hedge against further downside in crude-oil prices—a distinct possibility later this year and in early 2016.

Capacity increases and lower fares may bring back bad memories for many investors and weigh on passenger revenue per average seat mile (PRASM). But lower fuel prices and industry consolidation mean that this behavior, which is hardly on par with past offences, won’t crush the industry’s profit margins or send it into a tailspin.

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