It is amazing how the investment narrative can change.
2007: The below text has been extracted from Berkshire Hathaway Letter to Shareholders (I have underlined select words for emphasis).
The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines.
The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it.
.......recurrent, but always misguided, bursts of optimism for airlines. I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989.
2016: Imagine everyone’s astonishment when Berkshire Hathaway goes shopping, and picks up stakes in American Airlines Group Inc., Delta Air Lines Inc., United Continental Holdings Inc., and Southwest Airlines Co.
2019: By year end, it’s stake amounted to 11% in Delta Air Lines, 10% of American Airlines, 10% of Southwest Airlines and 9% of United Airlines.
2020: Berkshire Hathaway exits its stake in airlines.
And thereby hangs a tale.
If Warren Buffett had to describe his relationship with the airline industry, he would probably opt for “It’s complicated”.
When explaining his 2016 move on CNBC, he admitted that the airline industry has been a “disaster for capital” with “almost 100 bankruptcies”. But he went on to say that while airlines had a bad twentieth century, it is out of the way. That is the past. He seemed convinced that its fortunes changed for the better. When attempting to analyse Buffett’s change of stance, US Funds.com noted that by 2015, post consolidation and bankruptcies, the four mentioned airlines controlled about 77% of the U.S. airline revenue. And going by four financial metrics (return on equity, cash flow return on invested capital, net income margin, free cash flow per share), the industry was attractive.
Worth noting here is that years ago Morningstar asked a question related to Berkshire’s initiation of stakes in those four U.S. airlines. At that time, we pointed out that the airline industry seems to have few, if any, advantages-- even with the consolidation over the past 15-plus years. The barriers to entry for the airlines are few and the exit barriers are high. The industry also suffers from low switching costs and intense industry rivalry seen in pricing competition. Then there is the heavy exposure to fuel costs, with rising fuel prices being difficult to pass on and declining fuel prices leading to more intense pricing competition.
Greggory Warren, financial services sector strategist for Morningstar, notes that the airline industry is only ever one giant oil price spike away from having serious problems, and we weren’t surprised by the speed in which a black swan event like the COVID-19 pandemic brought the airlines to their knees.
Before the annual shareholders’ meeting, Gregg noted that, with regard to Delta, it was interesting to see Berkshire acquire close to 1 million additional shares at the end of February only to turn around and dispose of 13 million shares (as well as 2.3 million shares of Southwest) at the start of April. At that time he was unsure if this was just portfolio reallocation, given the increased risk to the industry, or the start of a larger move to eliminate the airline holdings from the stock portfolio completely.
We know that now.
The world has changed.
In an interview in February, Buffett stated that “if you own airlines for 10 or 20 years, you’re going to have ups and downs. The real question is, how many passengers are they gonna be carrying 10 and 15 years from now and what will margins be and what will the competitive position be?”
In an interview in March, Buffett reiterated that he “won’t be selling airline stocks”.
Come April, as the severity of the lockdown hit, the focal point changed: “We will not fund a company where we think it is going to chew up money in the future.”
Charlie Munger, in an interaction with the Wall Street Journal, noted that the airlines are completely in unchartered territory. “They’ve never seen anything like it. Their playbook does not have this as a possibility.”
In the history of aviation, the coronavirus pandemic and its consequent lockdown has resulted in the most disruptive global crisis the industry has ever faced. In a memo to staff entitled “The Survival of British Airways”, chief executive officer Alex Cruz, spoke of “a crisis of global proportions like no other we have known”.
UBS analysts said historic valuation anchors for airlines were no longer valid “given what is an unprecedented impact on the industry and evolving enterprise value composition.”
Airlines have stopped flying, resulting in thousands of planes being grounded. According to this report, there are currently around 17,000 aircraft parked up at airports around the world. Parking does not come free. Neither does constant aircraft maintenance. Airlines desperate to conserve their cash reserves as normal revenue streams have withered away, are looking at alternatives. Executive salaries are cut, share buyback programmes have been halted, aircraft is being sold, staff has been retrenched or put on leave without pay, and some have approached their respective government for a bailout package. Few have swallowed the bitter pill and filed for bankruptcy. As Munger said years ago, no airline can afford a shutdown very long.
This is the current situation.
Till a vaccine is discovered, social distancing and fear psychosis will play a huge factor in people’s reluctance to travel. If a global recession emerges, travel will be further hit. Add to it that one can no longer undermine the shifting attitudes towards work and business travel. If you can conduct business and attend a conference over zoom, why incur the exorbitant cost of travel?
British Airways' parent company International Airlines Group, or IAG, was quoted in BBC saying that it did not expect BA to see passenger demand return to 2019 levels for "several years". The key word being, “several”.
The speed at which the airline sector has nosedived with no recovery in sight is alarming. The International Air Transport Association (IATA) has pegged its expected 2020 passenger revenue losses for the world’s airlines to $314 billion. (source). Back home, Bloomberg reported that ICICI Securities estimates losses of Rs 5,494 crore and Rs 1,412 crore, for IndiGo and SpiceJet, respectively, for the quarter ended June if there is a complete lockdown.
Imagine the second and third order effects this would have on other aspects of the economy.
If this teaches us anything, when your investment thesis, no matter how sound and well researched, undergoes a change, act in accordance. You don’t owe your investments any loyalty.
So yes, the investment narrative can change. And the wise are not emotionally attached to it.