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Inside the Market Is the airline rally a sign of friendlier skies or a short-term lift?

Baggage is loaded onto an Air Canada plane at Toronto’s Pearson International Airport on Aug. 14, 2013. The airline sector is posting huge gains in the markets, and the forecast looks bright.

Deborah Baic/The Globe and Mail

The big rally in North American airline stocks this year is raising an urgent question among investors: Do the gains signal a sustainable shift in the industry or yet another short-term pop?

WestJet Airlines Ltd. is up 40 per cent this year, Southwest Airlines Co. is up 74 per cent, Delta Air Lines Inc. is up 130 per cent and Air Canada is up an amazing 256 per cent, touching its highest level in more than five years.

Anyone who has witnessed the dismal long-term track record of this industry is sure to point out that booms are inevitably followed by busts that leave investors with nothing. However, there are two things going for the industry that should make airline stocks far healthier investments than they used to be: higher efficiency and lower fragmentation.

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Cue the skepticism. Even as air travel has grown tremendously, rising tenfold over the past 40 years, and airline costs have fallen by 60 per cent after taking inflation into account, industry profits have failed to impress. According to the International Air Transport Association, the average net profit margin over the past 40 years is a scant 0.1 per cent – with even a very good year producing a profit margin of just 3 per cent.

A baffling number of airlines, including Air Canada and the parent of American Airlines, have filed for bankruptcy in recent years – implying that most buy-and-hold investors who bet on the trend of rising air travel (it's taking off!) have been wiped out.

This dismal track record implies that the current rally among airline stocks is based on nothing more than momentum and short memories, and is best avoided.

But when you give it a deeper look, you'll see that there is some substance to the moves, which should give the rally some longer-lasting heft.

For one thing, airlines are driving down their costs, which is a huge trend given how thin their margins are. In Air Canada's latest quarterly results, released last week, cost per available seat mile – a popular measure of efficiency – fell 3.4 per cent over last year and are projected to fall 2 per cent overall this year.

Okay, that hardly sounds like a revolution. But it was enough to drive Air Canada's third quarter adjusted net earnings to $365-million or $1.29 a share, up more than 59 per cent over last year and beating analyst estimates.

More broadly, it reflects industry-wide efforts to transform the way they do business. For example, most meals are now purchased on board, and they tend to be simple – raising revenue from passengers while reducing waste.

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Airlines are starting to benefit from the twin features of more efficient planes and lower fuel costs. Boeing Co., for example is rolling out its 787 Dreamliner, which boasts 20 per cent greater fuel efficiency than similarly sized planes.

According to the IATA, lower average jet fuel costs in 2013 have saved the industry some $3-billion (U.S.) – and few observers see any spike in energy prices in the years ahead, as the United States ramps up its domestic oil production.

The airline industry also appears to be benefiting from a recent round of consolidation – U.S. Airways has recently merged with American Airlines – that has vastly reduced the number of players in the industry. Whereas the industry used to operate with too many planes chasing too many passengers, leaving a lot of seats flying empty, the industry is starting to look like an oligopoly (in a good way).

For sure, airline stocks are still no place for risk-averse investors, and sharp rallies aren't usually the best times to jump aboard a sector. But rather than signalling trouble ahead, this year's rally reflects an industry that is going through some big changes – and that makes airline stocks look far healthier than they have in years.

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