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An Investment Roadmap – Risk-Adjusted Returns

When comparing investment returns it is misleading to simply look at headline figures. At first glance, it might seem an investment that gained 12% last year is better than one that gained 9%. In reality, it depends on how much risk was involved in generating those returns. The more risk (or volatility), the less probable the returns. The simplest way to measure risk is to look at the standard deviation of the returns. The larger the standard deviation, the riskier the investment.

Investors use the ‘Sharpe’ ratio, a ‘rewards to variability ratio’ to better compare alternatives. The ratio uses the standard deviation (a measure of volatility) to measure the ‘risk adjusted’ return. It’s a measure of the excess return over the risk-free rate relative to the standard deviation. It helps answer the question: “Is the ‘risk adjusted’ return worth the investment risk I am taking”?

Investing in commercial aircraft has historically demonstrated returns that adequately compensate for variability. Aircraft are hard assets with long useful lives*. It’s common for a commercial jet to remain in service 25 years or more. Some even longer, such as a 1970 Boeing 737-200 (serial number 20335), which is still flying with Airfast Indonesia (registration PK-OCG, based in the city of Jakarta, Surabaya and Denpasar). At 47 years, it may be the world’s oldest commercial passenger aircraft still in service (the second oldest 737 is registered to Johannesburg based Interair, South Africa, and, Kenya’s Trans African Air has a 42-year-old 737).

Profitability is just as important as equipment longevity. The International Air Transport Association forecasts global air carrier profitability will rise to $38.4 billion in 2018, up from an expected $34.5 billion in 2017. Operating margin, overall revenue, passenger and air cargo traffic, and average profit per departing passenger are all improving. 2018 is expected to be the fourth consecutive year of sustainable profits with a return on invested capital of 9.4%, which exceeds the industry’s average cost of capital of 7.4%.

IATA’s Director General and CEO recently stated: “These are good times for the global air transport industry. Safety performance is solid. More people than ever are traveling. The demand for air cargo is at its strongest level in over a decade. Employment is growing. More routes are being opened.” Operator challenges include fuel, labor, and infrastructure expenses which are rising. Performance drivers? Passenger and cargo growth. All regions are expected to report improved profitability in 2018. Global connectivity is vital to our modern lifestyle.

As a pilot, you identify and avoid turbulence (and if in turbulence, slow your airspeed). Information limitations can impact your ability to see and avoid. Similarly, in piloting investments, techniques are available for avoiding turbulence while enhancing returns. The complexity surrounding aircraft investment and residual valuation requires sector-specific expertise. Generating income, while retaining upside and liquidity over your investment horizon requires contextual expertise. Blue skies or stormy weather? Modern weather and radar equipment suggest you work with investment managers who have demonstrated abilities structuring transactions that produce, regardless of the weather. Generating such results requires an appreciation of risk-adjusted returns.

Aviation and Rail teamwork. We have the investment roadmap. Call RESIDCO.

 

*Delta operates 860 aircraft with an average age of 17 years, including a 30-year-old 757, and 30-year-old McDonnell Douglas MD-80s. American also operates MD-80s, the oldest of which was delivered in 1986.  British Airways oldest aircraft is a 747, registration G-BNLK, which it received on May 4, 1990
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Has Traffic Bottomed?

The first half of 2016 has seen its share of volatility. Globalization, central bank actions, the impact of the internet (speeding the flow of information and creating social networks), Presidential election politics, acts of global terror, and Brexit are all phenomena that have contributed. Historically, markets have not been as volatile.

Declining rail freight volumes continue to pressure North American Railroads[1]. July carloads declined 8.8%, led by coal at 17.5%[2] (U.S. coal production has dropped to its lowest level since 1981[3]). Crude by rail has declined 45% in 2016[4]. Class One railroads are storing more locomotives and railcars[5]. With less equipment on line increased train speeds have allowed the roads to more efficiently serve customers, further reducing equipment demand. Air travel is down due to terrorism and currency swings. Lower jet fuel pricing has improved margins and allowed air carriers to add capacity; the resulting competition has reduced revenue per available seat mile and increased pressure on air carrier yields.

Economic activity drives traffic, and demand for transportation influences equipment pricing at the margin. Transportation services cannot be ‘stored’. Unsold seats on a flight, unused air-cargo capacity, empty freight cars, and parked locomotives represent lost revenue. Are we at a bottom? The 34 nation Organization for Economic Cooperation and Development (‘OECD’) thinks so. The OECD expects U.S. growth, as measured by GDP, to slow to 1.8% in 2016, but to then accelerate in 2017 to 2.2%[6].

Political, policy, business, and investment leaders constantly grapple with the increasingly fickle cycles of consumer and business confidence. Is the world is in a ‘rut’ because of a chronic shortage of demand for goods and services and an extended period of low interest rates[7]? Short term thinking, uncertainty, over regulation, anxieties, and a lack of confidence in the future have impacted our economy’s structural growth rate and contributed to a deterioration in productivity. When economic freedom is suppressed, growth fades, and when growth fades it takes the American Dream with it. Our Presidential candidates? If elected, one has stated, “coal miners and coal companies will be put out of business[8]” as part of a clean energy agenda. In contrast, the other would reduce taxes and government regulation.

In this environment, agility, adaptability, and an open mind are essential tools. Asset allocation is critical and risk management is key. Volatility creates opportunities to buy equipment at discounted prices. Experience teaches staying the course proves its virtue in the long run. A long investment horizon diminishes the effects of volatility. Traffic may be down, but we expect it will stabilize through the rest of this year.

Choose wisely. Work with a firm that has a history of excellence, expertise and ethics. Call RESIDCO!

[1] Moody’s Investors Services, May 16, 2016.

[2] Association of American Railroads (‘AAR’) July, 2016 weekly U.S. rail traffic reports.

[3] Truewealth Publishing, July 21, 2016.

[4] August 3, 2016, U.S. Energy Information Administration, a division of the U.S. Department of Energy.

[5] Progressive Railroading, Rail News: Mechanical, Fleet Stats, July 2016.

[6] The Associated Press, June 17, 2016.

[7] Larry Summers, “Zero interest rates are a systemic inhibitor of economic activity.” Bloomberg Businessweek, May 12, 2016.

[8] May 2, 2016 Democratic presidential nominee, at a round table discussion with locals at the Williamson Health and Wellness Center in Williamson, W.V.

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