(MONEY Magazine) – If you think flying on an airline can be a miserable experience, try investing in one. The major airline stocks are down 25% since January because a slowing economy means fewer business travelers are buying those last-minute, sky-high-priced tickets that fatten airline profit margins. Throw in high fuel prices, tough labor negotiations and consolidation pressures, and it's easy to understand why most of the large domestic carriers are expected to declare losses for the first half.

Yet it's also looking like the best opportunity in quite some time for investors to make money on the right airlines. "Next year is going to be a very good year for the sector," predicts Eli Salzman, co-manager of Lord Abbett Affiliated fund, which owns shares of AMR Corp. and Southwest Airlines.

The case for a comeback

First, there's the prospect of a broad economic recovery spurred by the Federal Reserve Board's interest-rate cuts. As the economy revives, the increase in corporate activity should send business travelers back into airports. Another promising sign: Fuel prices are dropping. After touching $37 a barrel in September of last year, crude oil was down to about $28 a barrel in mid-June.

There should be improvements on the labor front too. Worker relations in the industry are tricky even in the best of times--and these are not the best of times. Pilots at Delta Airlines subsidiary Comair, for instance, walked out in March, an action that'll hurt second-quarter earnings and could've done even more damage if the pilots hadn't struck a deal in June to return to their posts. But Lord Abbett transportation analyst Paul Volovich notes that most of the industry's other major labor talks are on track to be settled by year's end, which should ease investor fears in this area. Arne Alsin, president of Alsin Capital Management, which owns numerous airline stocks, is even less concerned about the potential downside of contract disputes, arguing that rising labor costs don't really depress long-term profits. "Airlines are conduits," he explains. "They just pass on their costs, and the air traveler pays them in the end."

Alsin believes that many beaten-down airline stocks could shoot up by 50% once the economy shows signs of recovery. "Some of these stocks have the potential to double," he adds. There certainly is good historical evidence to suggest that airline stocks can rebound strongly. After breaking out of its last slump in December 1994, the airline sector has since trounced Standard & Poor's 500-stock index, gaining 203% through June 15 to the S&P 500's 164%.

One of the strongest candidates for a rebound is AMR, the parent of American Airlines. Thanks to AMR's recent acquisition of the assets of bankrupt rival Trans World Airlines, American now has more than 20% of the domestic air travel market and has overtaken United Airlines as the world's largest carrier.

Despite its leadership position, AMR has a price/earnings ratio of 9 (based on earnings for the past four quarters). First-half 2001 earnings have been a disaster, and many investors are fretting over the price of the TWA deal--with cash payments and the takeover of TWA's aircraft leases, the transaction is estimated to cost AMR $2.8 billion. A threatened strike by American's flight attendants hasn't helped either. But Lord Abbett's Salzman, whose fund owned 5 million shares of AMR as of March 31, says "those risks are fully factored into" the stock's recent $35 price. More important to Salzman is the fact that the TWA buy-out adds a key St. Louis hub to American's cross-country network. Besides, the stock is dirt cheap, trading at 0.8 times its book value--less than half the average price-to-book multiple for the sector. At such prices, AMR appears to be a classic value play.

Everybody's favorite

Looking for a growth stock in this sector? You're in good company. Growth guru Tom Marsico recently bought nearly 4.2 million shares of Southwest for his Marsico Focus and Marsico Growth & Income funds. (For more on the companies Tom Marsico has been buying these days, see page 41.)

It's hard to imagine who wouldn't want to own Southwest. Under legendary chief executive Herb Kelleher, this bargain-basement airline with mezzanine-level service has made money in good times and bad. It hasn't posted an annual loss since 1973. (Even in the gruesome first quarter of 2001, Southwest reported an after-tax profit of $121 million.) That record is the reason it boasts a market capitalization of $12.9 billion, larger than AMR's, Delta's and United's combined.

Yet at a recent $17, the stock is down 27% from its 52-week high. Many analysts lowered their 2001 earnings estimates for Southwest after May data showed that the airline's seating capacity was growing faster than its passenger traffic--a troubling trend that could force management to discount fares sharply. Another cause for concern: The 70-year-old Kelleher stepped down as CEO in June.

Keep those eyes on the horizon

Investors who peer beyond the short term, however, will find a company of awe-inspiring efficiency. In an industry where operating margins tend to be in the single digits, Southwest's margins were 18% last year. And Southwest's long-term debt is only 17% of its market cap. The average for the other largest airlines: 64%.

Despite their recent fall, Southwest shares still have a P/E of 21--at least twice what its peers are averaging. Then again, Southwest is in a class of its own, delivering 24% annualized earnings growth for the past five years and fetching a multiple as high as 36. ABN Amro analyst Ray Neidl expects Southwest to maintain its growth edge under new CEO Jim Parker, who's worked there for 15 years. "The people taking over have been around for a while," Neidl says. "They know what to do."

--ARAVIND ADIGA