US Global Investors recently launched the first exchange-traded fund that focuses on the airline sector. Here, we talk with CEO Frank Holmes about the make-up of fund, the outlook for the airline sector, the potential headwinds and tailwinds facing the industry, and the best positioned individual stocks within the airline sector.

Steven Halpern:  We are joined today by one of my favorite guests, Frank Holmes, CEO of US Global Investors.  How are you doing today, Frank?

Frank Holmes:  Outstanding…in a bear market.  

Steven Halpern:  Now US Global has long been known for its expertise is areas such as resources, gold and emerging markets, and in a more generally global investing, but more recently you've launched the first exchange-traded fund that's focused on the airline sector.  Can you tell our listeners a little about the background of US Global Jets ETF (JETS) and the make-up of its holdings?

Frank Holmes:  Sure. Well, from being a global traveler and flown 8 million miles commercially and seeing prices rise, I was wanting to figure out how can I do things less expensive and so I said the best way is to stop complaining and go create a product.  

There was no airlines industry ETF, and since I travel globally, I wanted to understand and went over and interviewed many different airlines’ analysts and took what the key factors were for picking airline stocks.

I then did other model factors and did regressional studies going back over ten years of restructuring, falling stock market prices, rising interest rates, all those scenarios, positive and negative, to put together a collection of stock that would do exceptionally well and would adapt and adjust to changes.  

We created what's called a smart beta and that smart beta is 80% US companies and 20% foreign, and what's interesting, Steve, is that when you go to Asia, you can buy the Beijing airport and the Bangkok airport, and in Mexico, several of the airports are listed on the New York Stock Exchange and they are perfect private equity infrastructure. They try to grow their revenue and cash flow at 15% a year.  

That means it doubles every five years.  This particular ETF has 33 names.  The four big names that dominate the portfolio, they get rebalanced every quarter and that's Southwest Airlines (LUV), Delta Air Lines (DAL), United Continental (UAL), and American Airlines (AAL).  

They are the most liquid names and they carry the bulk of the traffic.  Then we have JetBlue Airways (JBLU) and Hawaiian Air (HA), and we also have many, many other companies, but they still have to qualify on high cash flow returns on investor capital and growing revenue per share.  

Steven Halpern:  Lower fuel prices have been a windfall for the airline industry in general.  How important a factor is this and do you expect the benefits of lower oil prices to continue through this year?

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Frank Holmes:  Well, first of all, it is massive. Absolutely mind-boggling massive, but prior to this, prior to oil falling from $100 to under $30, these airlines—with all their additional fees and credit card fees and you can get an American Airlines credit card—well, they make $100 million a month from that credit card fees.  

All these additional things they did to the airplanes by having less first class and putting more economy and putting more seats per flight, what that did globally is took, in 2007 what was basically ancillary fees, from $3 billion to $40 billion. Mammoth!  

Then we have the windfall of oil falling. The numbers are just going to be gigantic. Like I said, spectacular numbers this quarter again because when you look at oil prices this quarter from last year, they are lower, and it really impacts American Airlines probably the most, along with Allegiant (ALGT) because they're unhedged.  

Whereas Delta owns an oil refinery and the other airlines like Southwest Airlines they have a hedging program and along with Alaska Air, so they hedge half of their cost structure every month, they roll out over 12 months.

It's a complex model but allows them to deal with the volatility and they're locking in, I mean, the numbers were thinking they were going to have $15 billion and then $20 billion and then $25 billion, you're going to have about $30 billion of free cash flow.  

Steven Halpern:  Now, on the other hand, one concern is raising labor costs. How much of a potential headwind is this?

Frank Holmes:  Well, they've got a lot of those contracts resolved and I think from that, when we look at the agreements and contracts, the falling fuel prices have more than offset any type of incremental costs to paying for the pilots and the stewardess, etc., the baggage crew.  That's not been as significant.  

What's going to be more important, what I find is the negative of Buffett.  He may have lost money in the airlines and everyone likes to quote it, but it's very different this time and there are three factors that say why it's different.  

First of all is the psychology and the attitude of CEOs.  They are buying back their stock and increasing the dividend.  They have never done that before.  They're not cannibalizing each other with more paths, more city paths, etc.  

They're using a software called Yield Management, that American Airlines used to use dominantly—but now everyone has it—and they all have their own quants that are basically like hedge funds that are using high frequency trading.  

They're using high frequency data and pricing and looking at loads factors they have to have and are necessary to make incremental profits.  They're much more sophisticated.

The third factor is that there are just less roots. There are less pilots. They can expand rapidly and there are rules that came in that said a pilot has to have 3,500 hours of experience, and with that, you saw that there is basically a shortage, that the government had to come up and change retirement.  

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The pilots used to be forced to retire at 60 and they had to go and demonstrate that they are actually healthier today than they were 20 years ago and now the retirement is 65, because, if they hadn't done that, we would have seen…I guess the number was 18,000 less flights a day.  

I think their capacity restraint for undercutting each other and that's why you're seeing that cash flow show up in new airplanes, expanding airports, buying back stock and increasing dividends, and paying their employees much better.  

Steven Halpern:  So, from a value standpoint, you recently stated that within the general industrial sector, airlines are the least expensive.  Does this suggest that now is an opportune time for long-term investors to be establishing positions here?

Frank Holmes:  I think so and I think that as we go with each new quarter of showing these record cash flows, will be a factor that shows up in all these screens of how inexpensive this industry is and if you look at the transport sector.

If you're worried about a slowing economy, well, the truck business and the railway business, they trade at much higher multiples, almost double…and I think that the airlines have their capacity constraints.

So, you can easily put more trucks on the road and you can easily carry more load on trains, but you can't do that with flying.  I think it's in a very unique position and it's going to be all of a sudden on a value proposition.  Money is going to start to flow into it.  

Steven Halpern:  Investors can get broad exposure to the airline sector via the Jets ETF.  I was wondering if you could comment on any individual airlines stocks that you might think are particularly attractive now for those who might be looking for specific stocks?

Frank Holmes:  You know, what I found so interesting when I was launching this was what they call the three-way traffic. I met hedge funds that only love JetBlue and Alaska Air (ALK), but they want to lower their risk of a short, so they go short the ETF.  

Then I find another group on the other side of the trade that only wanted to go short some of the more expensive—on a relative basis—airlines, but they want to go long on an ETF like this particular product.  

Then you have the investors that say, this is a value proposition, so you have this three-way traffic that's always taking place. With that, what I did, see, was there was less interest in United.  There is more interest in JetBlue. There is more interest in Southwest Airlines.  

What's interesting about those two is they standardized their planes.  United has a lot of the smaller aircraft and what happens when they use SkyWest (SKYW) is they outsource and partner with, anytime there is bad weather, it's the lighter planes, those flights get cancelled.

So you can turn around and easily be stuck at an airport and have got to make a connection to a bigger plane, but that smaller plane prohibits you from doing that.

Whereas Southwest always has the bigger Boeings and the same with the JetBlue; so their take-off and landing is more consistent and they're very price competitive.  

Steven Halpern:  Again, our guest is Frank Holmes, CEO of US Global Investors. Thank you so much for taking the time today.

Frank Holmes:  Well, happy investing.  

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