By Jon Sindreu

Guess which S&P 500 stock has gained 154% over the past year, beating Nvidia, Tesla and Netflix? Nothing related to artificial intelligence, data processing or energy: It is United Airlines.

The airline reported bumper fourth-quarter earnings this past week and suggested that 2025 could be a much better year than Wall Street was expecting. Its large trans-Atlantic footprint is an important advantage as a strong dollar encourages Americans to vacation in Southern Europe, even during the winter.

Similarly, shares in Delta Air Lines have risen 77% over the same period, with chief executive Ed Bastian saying that 2025 will be the best financial year in the company's 100-year history. And all this is happening amid elevated oil prices -- usually a big negative for airline stocks. It highlights a complete reversal of the pessimism that surrounded the sector last summer.

Are investors wisely anticipating the next supercycle in air travel or are they getting ahead of themselves and throwing their money into what Warren Buffett characterized in 2008 as "a bottomless pit?"

Those who look at the entire timeline since the Airline Deregulation Act of 1978 will probably tend to agree with Buffett.

If, 46 years ago, you decided to split $1,000 equally across the equity of the major U.S. network carriers and rebalanced your portfolio every month, at present you would have a paltry $3,342 in the bank -- $711 after inflation. Had you just tracked the S&P 500, you would have about $190,000 before inflation.

The numbers are shocking considering that travel demand has doubled during the period. But you might have noticed that few of the big brands of yesteryear are alive today. Pan Am, once the unofficial flag carrier of the U.S., went bankrupt following the rise in fuel prices caused by the first Gulf War. Trans World Airlines, Continental Airlines, Northwest Airlines and US Airways all ended up absorbed by United, Delta and American Airlines.

Yet investing in those survivors wouldn't have preserved your capital either: They have all filed for Chapter 11 bankruptcy in the deregulation era.

The problem with the airline business -- which Buffett identified after getting involved with US Airways in 1989 -- is that it is extremely capital-intensive but has deceptively small economies of scale. Carriers have a tendency to oversupply the market with seats, seeking the efficiency of a bigger network. But they have huge variable costs. Also, barriers to entry are low: Any upstart can easily finance or lease planes. Travelers put price above everything else, and quickly cut back when the economy sours.

In inflation-adjusted terms, U.S. domestic airfares have fallen by roughly 50% since 1978.

Indeed, the gains of the air-travel revolution have accrued to companies that make aircraft, not those that fly them: According to data by economist Kenneth French, aerospace ranks third out of 49 industries in total equal-weighted return during this period, whereas transportation is 28th.

Traditional full-service carriers have it worse because their complex "hub-and-spoke" networks be easily be downsized in a crisis. They rely on volatile corporate demand. The emergence of low-cost players, which fly smaller jets "point to point," demonstrated that hub airports weren't as big of a competitive moat as thought.

Of course budget airlines are no sure path to riches: Had you instead split your $1,000 among them, you would only have $9,426 now as a result of the failure of some of early adopters of the model such as People Express Airlines, and even some more recent disrupters such as Spirit Airlines.

Investing in U.S. airlines has actually been a winner-take-all game and the winner is low-cost carrier Southwest Airlines. Allocating the entire $1,000 budget to it would have left you with $314,000.

It might be possible to repeat the feat, but this time the big winners could be United and Delta.

Leisure fliers have emerged from the pandemic eager to pay for comfort and travel far. Suddenly, Southwest and other budget carriers are on the back foot and are trying to go premium like their legacy competitors. If travelers' hunger for a differentiated experience lasts, though, then budget carriers may struggle to catch up.

Earlier this month, United announced a deal with Elon Musk's Starlink to bring fast, free Wi-Fi to its fleet starting this spring. Delta has tested similar capabilities, and has invested heavily in luxury lounges. Meanwhile, there are long waiting lists to refurbish aircraft interiors.

"You just can't snap your fingers and make your generational investments overnight," United's Chief Commercial Officer Andrew Nocella told analysts this week.

At the same time, network carriers' recently developed ability to sell "basic economy" fares -- with checked baggage, seat selection, and in-flight meals charged as extras -- also allows them to threaten low-cost airlines at the low end of the market.

Some of these dynamics already played out in the 2010s. It was then that the modern, consolidated and capacity-cautious airline industry emerged from the latest wave of bankruptcies and takeovers. In this environment, a portfolio that selected better-than-average stocks from major network carriers -- essentially picking United and Delta and not American, which emerged in rough shape from its 2013 merger with US Airways -- did better than Southwest. It even delivered an impressive, 27 percentage-point pickup over the S&P 500.

Since 2022, the rising dominance of the new "Big Two" has increasingly been reflected in how their profit margins have kept widening even as most of the industry buckled under the pressure of higher operating costs and a glut of cheap seats that has lowered fares.

Take American: Though its stock has rebounded strongly from a distribution-strategy fiasco last year, it dropped 8.7% Thursday after executives issued 2025 guidance that was decent but fell significantly short of its peers.

Nevertheless, airline investors also need to remember that the 2010s were a period of unprecedented economic expansion immediately followed by the worst crisis in aviation history -- the pandemic. Buffett, who had disregarded his own admonitions and gotten back into airlines in 2016, got burned. Despite Delta and United receiving government bailouts, their shares took five years to recover.

Yes, such extreme episodes are exceptional, but the history of Southwest's stock is instructive: While on average it has outperformed the S&P 500 over five-year stretches by 1.3 percentage points annually since 1978, it suffered a 13.2 percentage-point average underperformance during monetary-easing periods ending in a recession.

Even if Buffett is wrong, the best airlines still become uncomfortable when turbulence hits.

Write to Jon Sindreu at jon.sindreu@wsj.com

(END) Dow Jones Newswires

January 24, 2025 05:30 ET (10:30 GMT)

Copyright (c) 2025 Dow Jones & Company, Inc.