I continue to remind myself and all investors that “it is a market of stocks, not a stock market”.

Inside a bear market, or high volatility, there are always companies whose earnings are rising. I am trying to use this period of volatility to increase my weightings in companies I believe can continue to grow earnings (and dividends) over the next 12 to 18 months.

Let me be very clear though, I absolutely do not believe this correction in markets is over. All we may have seen is a classic bear market rally in the last few weeks that squeezed a few shorts. If you look at bond, credit, commodity and currency markets, they are telling you to be sceptical of any aggressive market rallies in equities. Remember, bear market rallies are the most violent of all and I tend to suspect we just experienced one.

We need to remain patient and highly selective in our investments. It is absolutely not the time to buy everything, it is a time to be sensible and increase conviction in companies that can grow, despite weakening global growth and deflationary pressures.

This could easily end up being a very tough year at the index level, globally and locally. Years that start badly tend to do badly. However, before we give up all hope (and Peter cuts me off as a contributor — #joking), just like last year there will be stocks that gain +20%, even if markets fall another -10% on risk aversion.

What I am trying to do is find those ports in a storm. Recently, we saw strong Australian companies sold to fund rotation to weaker companies. We saw some “profit take the fact, short cover the fact” in the reporting season. I think that rotation has come to an end and it is now time to add to ONLY the strong. Premature contrarianism can be a VERY expensive strategy.

Today I want to revisit an iconic Australian brand: Qantas (QAN). QAN was one of my best ideas a few years ago when we rode the stock from $1.00 to a little over $3.00. At that price, I recommended switching from the airline to the airport, recommending a switch to Sydney Airport (SYD) at around $5.00. That switch worked reasonably well, with SYD outperforming QAN by around +10% (inc distributions) since that note.

SYD recently reported very strong numbers and I am happy to keep holding them, but after the unreasonable pullback in QAN shares, after reporting record earnings, I think it’s time to buy QAN again for the earnings growth, buyback and potentially dividends that they will pay over the forecast period ahead.

Let’s start the QAN thesis at the macro level. I am a huge believer in the Chinese international tourist and Australia’s ability to capture an increasing proportion of those structurally growing Chinese international tourist dollars.

In the SYD 2015 result, they confirmed total passengers grew 3% to 39.7 million. International passenger growth was 4.3%, and domestic 2.3%. The international growth was driven by services commencing from six new airlines.

Chinese national passengers grew by 17.8%, second only to the 36.7% growth registers from the Philippines. Capacity from China grew 8% to 1,301,616 seats per annum.

Those numbers were from 2015 and since then SYD has released their January 2016 traffic statistics, which were exceptionally strong. SYD experienced total passenger growth of +7.5% in January, driven by a +9.5% rise in international passengers and +6.2% rise in domestic passengers. Obviously, there is a domestic network effort of the growth international passengers. To put this in context, January was SYD’s strongest passenger growth month in over a decade, driven by Chinese arrivals being +38.9% year-on-year. SYD expects to welcome 430,000 Chinese passport holders during the peak January to March lunar new year period.

I believe these numbers are structural passenger growth. This is great for QANTAS because a rational duopoly has also formed in domestic aviation, which is seeing fare price rises and margin improvements. This is despite fuel prices collapsing. To put that in context, QAN’s 1H domestic EBIT rose from $225m to $387m, while operating margin rose from 7.5% to 12.9%.

In the international business, EBIT rose from $59m to $270m, while operating margin jumped from 2.1% to 9.1%.

All in all, this drove QAN’s best first half in its history. Yes, many of you will say “it’s all the oil price”, but it’s not. This company is being run far more efficiently and milking its strategic advantage as Australia’s flag carrier. This is a really good set of numbers below, and I expect them to continue for the next 12 to 18 months.

For a company that many commentators had “going broke” at the bottom, 1H net free cash flow of $770m and an associated $500m buyback should end that debate.

The operational segment EBIT contribution is below, reminding you again that loyalty (QAN Frequent Flyer) is a growing and very valuable annuity stream. Loyalty generated $176m (up from $160m) of EBIT at a 24% margin. Now that’s a nice business on any measure. QFF now has 11.2m members, +700,000 over the year.

It’s also worth noting the strong EBIT contribution from Jetstar. Jetstar EBIT grew from $81m to $262m, while margin grew from 4.6% to 13.7%. EBIT was reduced by $23m due to Indonesian volcanoes, suggesting the 2H will be even stronger. Jetstar is another genuinely valuable standalone business that gets somewhat forgotten in the QAN group share price.

Interestingly, QAN’s “dual brand” coordination continues to deliver profit share above capacity share. EBIT share is 80% vs capacity share of 62%. QAN serves business and premium leisure customers, while Jetstar serves price sensitive customers such as fund managers!

This is a very, very interesting chart.

The good news is this multiple stream EBIT grow and free cash generation is seeing QAN’s balance sheet improve. QAN regained an investment grade credit rating from S&P in November 2015 and QAN’s gross debt to EBITDA appears headed below 3x.

Group “fleet age” has dropped to eight years, which increases efficiency, in particular fuel consumption and maintenance. This low felt age in a low oil price environment is driving operating margins.

The execution of the strategy has been excellent under Alan Joyce. QAN describes it as building on the group’s long-term competitive advantages.

In terms of valuation and earnings, QAN remains cheap. Yes, it’s an airline and airlines deserve discounts, but it’s a very dominant airline that has four separate earnings streams, all of which are headed in the right direction.

I forecast QAN to generate EPS of 62c in FY16, rising to 70c in FY17. During that period, QAN will buyback $500m of shares on market, which will improve EPS but also provide support for the share price.

At the current share price of $3.90, that puts QAN on an undemanding FY16 P/E of 6.3x and FY17 P/E of 5.5x. I think that FY17 P/E will prove too low and I expect that to rise to closer to 7x FY17 earnings, as the market gets more comfortable that QAN can deliver those numbers. 7x FY17 equates to a $4.90 share price target, which is in line with the current analyst consensus share price target of $4.97.

Quite simply, if this macro and micro (top down/bottom up) momentum continues for QAN, there’s a good chance QAN will be a $5.00 stock over the next 12 to 18 months.

Yes, it is an airline, but it’s really three airlines and a financial services company. That differentiates from ALL other listed airlines globally. In fact, you could argue it deserves a premium to its globally-listed peers.

The AIM Global High Conviction Fund owns QAN shares.

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