Which is the better investment right now, Southwest Airlines (LUV) - Get Report or Continental Airlines (CAL) - Get Report?

Southwest looks as if it will be the only major airline to show a profit this year, and the company likely finished the September quarter with better than $1.3 billion in cash. That makes Southwest one of the financially strongest airlines in the industry.

Continental, on the other hand, will show a loss. The most pessimistic analyst on Wall Street expects the company to lose about $10 a share in 2001. The company is best-described as financially challenged. Its debt-to-equity ratio is almost 50% higher than the airline industry average, and all of Continental's assets are already pledged to various loans, bank lines and credit arrangements.

And yet, if the downturn in airline traffic isn't worse than most Wall Street analysts expect and doesn't last significantly longer than they project, owning Continental over the next year likely will be more profitable than owning Southwest. Smith Barney, for example, is looking for a tidy 22% return on Southwest shares in a year, but a mouthwatering 69% return on Continental.

Of course, there's a catch. There's always a catch in investing any time you see numbers like that. If the downturn is worse than expected, Southwest shares won't gain that 22%. Probably, they'd stay about where they are or, at worst, return to their September lows of about 15% below the recent price. But there's little chance that Southwest will go bust. Besides its current cash balance and profitability, the company has $3 billion in unencumbered assets it can borrow against and a tiny 0.2 debt-to-equity ratio.

Continental, on the other hand, could see bankruptcy. Again. The company filed for bankruptcy in 1983 and again in December 1990. Bankruptcy isn't kind to bondholders who get back just a small fraction of their investment, but it's absolutely devastating to stockowners. Typically, they wind up with nothing.

So which is the better buy -- Southwest with its promise of a relatively risk-free 22% return, or Continental with its spectacular upside and its horrifying downside?

The 'Right' Risky Stock

The stock market is currently rife with decisions like this. Is it better to buy

Dell

(DELL) - Get Report

, with its promise of a 35% return in a year or go for it with

Brocade

(BRCD)

or

RF Micro Devices

(RFMD)

? Among financials,

Citigroup

(C) - Get Report

or

E*Trade

(ET) - Get Report

? Among manufacturers,

General Electric

(GE) - Get Report

or

Xerox

(XRX) - Get Report

?

And we know from history that buying stocks of the companies with the most risk at a time like this can yield the highest returns -- if you pick the right risky stocks. The last time that the airlines went through a crunching cyclical downturn like the present one was in 1994-1995. Investors who bought the financially strongest stocks in the group on Oct. 1, 1994, did quite well over the next 12 months as the industry recovered, according to calculations by Salomon Smith Barney. Southwest climbed 12%, American Airlines' parent

AMR

(AMR)

rose 40%, and

Delta Air Lines

(DAL) - Get Report

gained 55%.

But those investors who picked the survivors among the financially shakier stocks in the group did even better. United Airlines' parent

UAL

(UAL) - Get Report

soared 97% in the next year and Continental roared 112%.

Risky but wrong picks, however, carried a heavy price. Trans World Airlines filed for bankruptcy in June 1995.

So how do you decide between Southwest or Continental, Dell or Brocade, Citigroup or E*Trade? How do you choose between the potential for solid profit with tolerable risk and home-run returns with a truly scary downside?

To answer that question, let's look at the risk/reward logic that argues in favor of buying Dell. The upside on Dell under most reasonable stock market and economic scenarios is 35% in a year. The downside on Dell under most reasonable stock market and economic scenarios is a loss of less than 20%. Decision: Buy Dell.

That framework works well for a stock like Dell, which doesn't have a devastating downside. But applied without modification, it doesn't do a good job of telling an investor what to do with the type of stocks dominating today's market: those that could potentially produce both extremely high returns and devastating losses.

A Two-Pronged Strategy

Let me extend this analysis by moving in two directions at once. First, investors need to come up with not just reasonable best- and worst-case returns and losses, but also some sense of the probability of those results. Second, investors need to consider possible strategies that could limit the downside potential of risky stocks.

Let me continue with my original example of whether to buy Southwest or Continental to demonstrate what I mean by looking at the probability of the best and worst cases. Before I can decide whether I'm willing to take a chance on a 69% potential return with Continental over the 22% potential return with Southwest, I need to ask how likely is it that Continental could wind up in bankruptcy or near bankruptcy.

Fortunately, the airline industry has a clear history of what happens as it goes through its periodic contractions and expansions. When seats are in oversupply, as they were even before Sept. 11, airlines first slash fares in an effort to fill planes at any price. When that doesn't work they reduce capacity by cutting flights and grounding planes. When demand comes back into alignment with capacity, airlines temporarily make a lot of money as planes fly near capacity and prices firm. And then, the airlines add flights and planes and begin the cycle all over again.

For the current cycle, it looks as if the industry is headed toward slashing capacity by about 20%. That doesn't mean that every airline will suffer the same loss of business. Some will do better. Southwest, for example, may actually wind up adding capacity in key markets, such as Baltimore-Washington, as early as the beginning of 2002. And some will do worse:

US Airways

(U) - Get Report

and

America West

(AWA)

look like clear losers, and Delta could suffer significant damage.

How can I say that? Because the long cyclic history of the airline industry indicates what kind of airline loses the most passengers in a downturn and what kind of airline finds it hardest to regain those passengers in a recovery.

Most airlines in the U.S. are built around a varying mix of hub and nonhub routes. Hub routes are flights out of one of an airline's hubs, such as Dallas-Fort Worth for AMR or Atlanta for Delta. Nonhub routes, as the name says, are flights that originate in airports that aren't a major hub for the airline. It's relatively easy to hold onto or recapture hub traffic after capacity cuts. A passenger traveling on Delta through Atlanta can be steered to another Delta flight even if the airline has had to reduce the frequency of flights to his destination.

Nonhub traffic is much tougher to recapture. Once a route has been cut, potential passengers are likely to fly on a competing airline or use alternative means of transportation. In either case, a cut in capacity will result in a disproportionately large drop in passenger traffic for the airline because the passenger can't be steered easily to fill the seats on that airline's other flights.

A high percentage of connecting traffic vs. local traffic is also a drawback. Connecting passengers have many alternatives and little loyalty to a specific carrier, and are likely to switch. Passengers that come to the airport from the local area are likely to have more limited choices and more carrier loyalty, and are less likely to switch.

So how do these factors play out for Continental? The airline has one of the strongest hub networks in the industry with large local hub markets that minimize the airline's dependence on connecting traffic. Continental should be able to cut capacity while keeping traffic higher than many of its competitors. It also should be able to regain passengers at a faster rate once the downturn in air travel ends.

Continental could go into bankruptcy -- the company's financial position is dangerously illiquid -- but the strength of the company's basic business structure makes that a low probability event. And the airline is actually likely to benefit from the failure of weaker competitors.

Reducing Risk

So losing all your money by investing in Continental is a "low probability event," you might be thinking. Swell. Can an investor reduce the odds even further?

In a situation like this, risk reduction strategies aren't complicated or novel. First: Wait for more information. Every month that goes by will give us better numbers on how fast passengers are returning to flying and a better sense of how the federal airline bailout money will be distributed. Waiting too long will take the uncertainty premium out of a stock like Continental. But a month is likely to provide extremely useful data. Second: Hedge with noncorrelated investments. Strategies here can be as complicated as using

options and futures to limit the downside, or as simple as diversifying by buying a stock that's likely to perform well if Continental does badly.

Princeton Review

(REVU)

, for example, seems to be seeing an uptick in sales of its test preparation services as a slumping economy sends more people back to get more education. Third: Use

dollar-cost averaging. This is a form of enforced delay because you buy your shares over time, linked to a discipline that purchases more shares when the price is low and fewer when the price is high. From my email, it seems to be on a lot of investors' minds at the moment.

And where does this leave me on Continental vs. Southwest? Inclined to buy Continental but willing to wait a month to get a little more of the uncertainty out of the stock.

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Citigroup, Dell, E*Trade and Global Crossing.