Ask Warren Buffett, CEO of Berkshire Hathaway (BRK-B) what he thinks about investing in airlines, and you’re liable to get a rather scathing answer. After all, the Sage of Omaha famously suggested that it would have been a great day for capitalism had someone responded to Orville Wright’s debut flight in North Carolina by shooting down the aviation pioneer. “A durable competitive advantage has proven elusive ever since the days of the Wright Brothers,” he went on to to grouse not long after having had to write off 75% of his $375 million investment in U.S. Airways (LCC).
That’s a rare black eye for Buffett, and may well explain his enduring skepticism about the ability of the airline industry to generate profits for investors. The problem? The recent evidence -- seen in the stock chart below -- and the industry’s new trends suggest that Mr. Buffett may be allowing that experience to blind him to a potential source of both and future investment returns.
True, investing in airlines isn’t for the faint of heart. As the chart above shows, their gyrations make the performance of the S&P 500 look downright turbulence-free over long stretches of time. Little wonder, then, that stocks like Delta Air Lines (DAL) have been favorites for hedge fund managers who are more comfortable with thinking like traders -- like David Tepper of Appaloosa, Ospraie’s Dwight Anderson, Julian Robertson protege John Griffin, now at the helm of Blue Ridge Capital, and even the venerable George Soros -- than with those who prefer a plain vanilla buy-and-hold stock.
Portfolio managers who want to avoid stocks that they’ll have to trade frequently in order to capture profits have opted to steer clear of the group. Why, they argue, put good money into companies that can find their revenues and profits buffeted not only by the economic environment but also by labor disputes, jet fuel prices, the weather and, of course, terrorism? The bankruptcy filing by American Airlines and its parent company, AMR (AARMQ) simply seemed to prove Buffett’s point that these are dangerous additions to the portfolios of any sober-minded value investor.
But the airline universe just isn’t what it was a few years ago. For instance, when AMR emerges from bankruptcy protection, it will be as part of US Airways, becoming the world’s single largest airline. Indeed, the new behemoth, Delta and United Continental (UAL) combined will account for about 75% of all air passenger miles flown in the United States. Throw in Southwest (LUV), and you’re up to about 80%. But the forward PE ratios for these four top airlines remain low in both absolute and relative terms, a signal that the market may so far be refusing to recognize that the consolidation will give this handful of companies greater control over pricing.
True, there are still some headwinds. The sequester-related budget cuts took a toll on flight bookings, especially on so-called late flight bookings, made on short notice and typically commanding higher prices. US Airways blamed the fact that its passenger revenue per available seat mile was flat in March on the federal government’s forced budget cuts. In spite of that, however, the airline reported that its load factor -- the percentage of seats that were occupied on its flights -- rose from 84% to 85.6%, even as it has made more seats available to passengers. Meanwhile, the airline has also been taking steps to operate more efficiently that likely will continue to show up in its earnings statements down the road, such as a shift to replacing smaller aircraft with larger ones and more long-haul flights. Recognizing the improvement in US Airways’ credit position, Fitch Ratings boosted its rating on the company’s debt by two notches: it may still be speculative, Fitch says, but even without the benefit of the American Airlines merger, the company’s financial position is more stable.
There also is good news at United Continental, which will remain he world's largest airline until that US Airways/AMR merger takes effect. The company’s revenue per mile flown rose as much as 7.5% in February, and its revenues are expected to feel the benefit from the end to what has been a bumpy switch to a new, integrated passenger-reservation system that took place last year.
Airlines may never be stocks that serve to anchor a portfolio or provide reliable and consistent returns: their fortunes are too closely tied to the economy and to factors outside their control, such as jet fuel prices. But that doesn’t mean that a value-oriented investor should steer clear of the group. As the warnings on all mutual fund products remind us, ‘past performance is no guarantee of future results’, and while each of the major airlines carries with it its own set of risks, the overall picture is one of an industry that consolidation is in the process of reshaping and -- potentially at least -- making more profitable for its investors.
Suzanne McGee, a contributing editor at YCharts, spent nearly 14 years as a reporter at the Wall Street Journal, in Toronto, New York and London. She is also a columnist for The Fiscal Times, and author of "Chasing Goldman Sachs", named one of the best non-fiction books of 2010 by the Washington Post. She can be reached at firstname.lastname@example.org.
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