By Vitaliy Katsenelson
Even before the coronavirus, my firm was not a big fan of the airline business. Planes are expensive. Airlines have to pay for them during normal economic times and recessions. Their other big cost is fuel — airlines have little control over it. If they hedge the price and it goes up, they are heroes. If they hedge and it declines, their unhedged competition will have an economic advantage. Moreover, customers usually have little loyalty and price is the deciding factor most of the time.
Warren Buffett invested in the airline industry in the 1980s, lost money, and swore he’d never invest in it again. Yet after the Great Financial Crisis the airline business went through significant consolidation by mergers and attrition, leaving just four carriers controlling the bulk of the U.S. market. Fewer competitors made competition more rational and turned these airlines into much better operators.
So Buffett changed his mind and bought into each of the four largest U.S. airlines. For a few years it seemed that he’d made the right call. Indeed, for some value investors, the airlines had been blessed by the high priest. As for my value-stock focused firm, we passed on the airlines without spending much time thinking about them.
It’s plausible that when Buffett’s Berkshire Hathaway /zigman2/quotes/208872451/composite BRK.A +1.54% /zigman2/quotes/200060694/composite BRK.B +1.32% bought those airline stocks in 2015, he thought the worst case for them would be a significant recession where plane occupancy would fall to 50%-60% from the usual 80%-90% His thinking might have been that the airlines would suffer losses for a few quarters, but the recession would not be an existential crisis for them. Recessions last months and expansion go for years, and it’s a safe assumption that Buffett thought the airline stocks he bought were cheap on full-cycle (both recession and expansion) earnings.
Despite being the Oracle of Omaha, Buffett did not foresee that one day we might have a different type of recession — where 95% of all planes would be grounded, not because people couldn’t afford to buy a ticket but because they would be required to stay home by their governments, or would be afraid that close proximity to others would make them sick or even kill them.
Few businesses can survive when 95% of their revenue goes away for an extended period of time. Even fewer can survive when they have a large fixed-asset base that needs to be paid for whether they are using it or not, as the airlines do. Against those odds, Buffett last May announced that Berkshire had sold its entire position in the airline business.
The sad reality is that unless airlines raise new capital, they will go bankrupt. This capital, though it might save them, will reduce the value of their businesses. Equity issuances would permanently dilute shareholders, as future earnings will be shared with a much-increased shareholder base.
If the airlines issue debt, it will not be cheap capital, either, and will burden these companies, which already have a lot of fixed costs, with another cost — significant interest payments that will substantially reduce their future earnings power. The longer the fear of the coronavirus lingers on, the more money these companies will lose and the greater the damage that will be done to their balance sheets and thus their future earnings power.
In our thinking about the virus we have three timelines, or eras: B.C. — before coronavirus, D.C. — during coronavirus (now), and A.C. — after coronavirus (the virus is completely gone, or there is a vaccine or effective treatment. The longer the D.C. era lasts the more impact it has on the A.C. era. The D.C. era comes with high unemployment and enormous government spending — larger deficits and an ever-growing debt pile. The A.C. era for the airlines is path-dependent, and they have little control over that path; it is controlled by the virus (or the fear of the virus).
Typically in a recession, you can look at the rear-view mirror earnings for a cyclical company like an airline and that becomes your goal post for future earnings power within a year or two, max. Now, no one knows how long it will take for the earnings power of airlines and the travel industry as a whole to return to pre-COVID-19 levels.
Here is what we believe: Though it is hard to imagine, the fear of COVID-19 will eventually go away, either because there is a vaccine or a cure, or because the virus is gone, or because we will simply adapt to its existence. We’ll change our behavior, and that will happen slowly. We’ll make a lot of small decisions; each will be a tiny compromise that will nudge us out of our fear. Airline travel will be no different — flying will require a great many little, incremental, marginal decisions before we overcome the fear of boarding a plane.
So, how does one invest in this overvalued market? Our strategy is spelled out in this fairly lengthy article.
Vitaliy Katsenelson is chief investment officer at Investment Management Associates in Denver, which owns shares of Berkshire Hathaway in client portfolios. Katsenelson is the author of “The Little Book of Sideways Markets” (Wiley).