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Rupert Hargreaves
Rupert Hargreaves
Articles (307)  | Author's Website |

Buffett and Airline Stocks

Guru's investments in airlines in 2016 prompt speculation about his position

Airline stocks took off in the third quarter last year after it emerged that billionaire investor Warren Buffett (Trades, Portfolio) had acquired stakes worth more than $1 billion in several U.S. airlines.

Specifically, according to Berkshire Hathaway’s (BRK.A)(BRK.B) 13F SEC filing, Buffett and his lieutenants bought shares of Delta Air Lines (NYSE:DAL), American Airlines (NASDAQ:AAL) and United Continental (NYSE:UAL) at $249 million, $797 million and $238 million during the third quarter (values based on a quarter end market values). In the days after the stakes were revealed, Buffett announced that Berkshire had also acquired a position in Southwest Airlines (NYSE:LUV).

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Berkshire’s new carrier positions have sparked a debate about whether Buffett has suddenly changed his opinion on airlines. The Oracle of Omaha has long avoided the airline sector, due to its unpredictable nature, uncontrollable margins and record of destroying shareholder equity. But by buying over $1 billion in airline stocks, Buffett has shown the market he now appears to be warming to the sector. Does this mean other investors should follow suit?

Time to buy airlines?

Following so-called super investors into positions just because 13F filings detail the holdings is never a sensible strategy, and this is something to keep in mind when evaluating all of Buffett’s portfolio movements. Even though the billionaire is best known for his long-term investing outlook and ability to pick winners, that’s no guarantee that he is investing for the long term this time around.

Indeed, Buffett's airline buys are relatively small compared to the rest of his portfolio (it’s more than likely that Buffett’s lieutenants picked these investments due to their small size) and are, therefore, unlikely to be long-term holdings. In fact, Berkshire could have already sold the holdings and booked gains made over the past few months.

Assuming Berkshire hasn’t divested its airline holdings, it remains a mystery why Buffett’s conglomerate likes these stocks. True, the market for airline travel is growing, costs are falling, and carriers are becoming more efficient, but the negative factors that have always plagued the industry remain.

Airlines’ largest expense, fuel margins, tend to be volatile over the long term as a result as high fuel costs erode profits. Even though the shale oil boom has gone some way to ensuring that oil prices will remain lower for longer, the cost of fuel remains a significant uncertainty for airline management.

Second, airlines remain exposed to price wars. They are engaged in a race to the bottom when it comes to fares as they look to offer the lowest cost to customers and win more business. Even if ticket prices do stabilize there’s no guarantee this ceasefire will last for the long term.

Finally, airlines are still highly capital intensive businesses, and this will not change. Unlike almost all of Buffett’s other significant long-term investments, such as Coca-Cola (NYSE:KO), American Express (NYSE:AXP), IBM (NYSE:IBM) and Wells Fargo (NYSE:WFC), airlines have relatively low return on invested capital. The significant upfront capital investment required to acquire a fleet of planes takes years to pay off unlike businesses such as Coca-Cola and American Express, which can generate a high return on a small asset base.

What's Buffett's plan?

So what could it be that Berkshire likes about the airlines? Well, it could be something to do with the airlines’ valuation at the time or potential for growth if U.S. economic expansion picks up.

Ultimately, though, it’s not possible to know exactly why Berkshire bought Delta, American, United and Southwest during the third quarter of last year. The airline industry is still likely to suffer from its traditional problems going forward and does not appear to be a sensible investment for long-term investors at all. Buffett may have his reasons for buying, but most investors might do well to stay away from the airline sector.

Disclosure: The author owns shares in IBM, but no other company mentioned.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. Prior to his investing and writing career, Rupert was as a proprietary currency trader. Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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Rating: 4.7/5 (3 votes)

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Comments

batbeer2
Batbeer2 premium member - 8 months ago

Thanks for an article worth reading.

You say: but the negative factors that have always plagued the industry remain.

Then you go on to list three:

1) ... the cost of fuel remains a significant uncertainty for airline management.

2) .... Airlines remain exposed to price wars.

3) ... Airlines are still highly capital intensive businesses,...

FWIW I think none of these factors are root causes. They also apply to a number of highly profitable industries. Take railroads in the US. They need fuel and are capital intensive and yet they've done well in recent decades. Interestingly, not every railroad on the planet has done well. It's just railroads in the US. So how did the industry wake up one day and decide to stop being unprofitable.

There was another factor at play; regulatory change.

Also, it is remarkable that just about every other player in the value chain — airports, airplane manufacturers, jet engine makers and service companies (to name a few) is profitable. Ironically only the companies that actually move passengers struggle.

So I'll share what I think are two root causes for the poor performance of the airlines.

1) Unions. The operations of an airline are dependent on a large number of small unions. The guys loading the suitcases, controlling air traffic, serving the drinks, doing security checks, etc. etc. etc. all have their own union and ALL can stop your entire operation at the blink of an eye. 12 air traffic controllers based in Iceland could organise themselves and threaten to shut down a large chunk of the northern hemisphere unless they get a 25% raise. Stuff like that. Ironically, the smaller the group, the cheaper it is to give them a huge raise and avoid being shut down.

2) You have irrational competitors. Airlines were and in some cases still are an extension of the governments of their home markets. Once upon a time Pan Am was the US. Air France was France, not to mention Aeroflot etc. etc.

If you are trying to run a profitable international airline you will encounter something called Emirates. They are of course wholly owned by the government of Dubai. That government will not bother denying that they support the rapid development of their airline at the cost of any and all other globally operating airlines.

That is tough to compete against for the likes of Delta, JAL and Qantas who may not have signifcant (tangible or intangible) government support.

AFAIK Emirates is not going away any time soon but perhaps someone knows about some regulatory change within the US that might affect the power of the unions in relation to airlines?

Just some thoughts.

Rupert Hargreaves
Rupert Hargreaves - 8 months ago    Report SPAM

You raise some good points all of which add to the case of uncertainty. I think the main overbearing point here is lack of pricing power. All of the issues above add to one main factor: the airlines actually have very little control over their own businesses and this hasn't and won't change any time soon. So, the question of why Buffett has suddenly gained a liking to them remains....he's always avoided such businesses in the past...

batbeer2
Batbeer2 premium member - 8 months ago

>> the airlines actually have very little control over their own businesses and this hasn't and won't change any time soon.

It seems Buffett disagrees. I don't know why but that is what I'm trying to figure out. My point is that the things you mention (volatile fuel etc) are not going away but they can not be the cause of the losses. This has been proven by many companies that need fuel and lots of capital that do report growing profits.

So if there was some unknown factor eating away the profits that has now disappeared then to me that would be worth figuring out.

I'll let you know if and when I think I've figured it out.

Rupert Hargreaves
Rupert Hargreaves - 8 months ago    Report SPAM

Would be interesting to hear what you find!

jtdaniel
Jtdaniel premium member - 8 months ago

Hi Rupert,

Thanks for the fine article. Mr. Buffett may have foreseen deregulation and consolidation (e.g. United Continental), two factors in the increased profitability of US railroads, but I think this was more likely a pure value play on a cyclical upturn. It would have been right out of his play book, with refiner Phillips 66 (PSX) perhaps the most recent of many examples.

Southwest Airlines (LUV) had been the only airline stock (adequate balance sheet) on my watch list for years, and I bought at 9X EPS on September 15 at $36.92 per share. This was about two months prior to the news that Berkshire had purchased shares of LUV and other US airlines in the 3rd Quarter of 2016. The fact that Mr. Buffett bought into a basket of airlines could indicate a cyclical value play on the industry or simply that the dollar amount of the investment necessitated a basket approach. If this was just a cyclical play, I would expect a 2-3 year holding period.

Best, dj

vgm
Vgm - 8 months ago    Report SPAM

Thanks for the interesting analysis.

However, although they're Berkshire buys, I'd be pretty sure these airline purchases have nothing to do with Buffett. Rather these will be Combs and/or Weschler picks. His lieutenants operate completely independently of him - and invest much smaller amounts of money than their boss.

At a recent Berkshire meeting, Bill Miller submitted a question based on the attractiveness of airline stocks, on account of consolidation in the sector. Buffett said that Miller may be right but that he (Buffett) was not interested. And, if I remember well, Munger said he too would not be interested in airlines.

Bill Miller was invested in airlines well before the Berkshire buys and has profited greatly as those stocks rose due to the Berkshire effect.

Rupert Hargreaves
Rupert Hargreaves - 8 months ago    Report SPAM

Dj and Vgm,

I agree with both of you, these are likely to be short-term (relative to Buffett's normal holding periods) trades made by Combs and/or Weschler -- as noted in the article.

vgm
Vgm - 8 months ago    Report SPAM

Thanks, Rupert.

A couple of points: if we agree that these are not Buffett buys, then maybe your title needs to be changed. It's arguably misleading the way it is - and your subtitle too for that matter. Second, although Combs seems to buy and sell with a relatively short timeframe (at least in some cases), Weschler is more a long term buy and hold investor who buys few but very large positions - see for example DVA and GM.

vgm
Vgm - 7 months ago    Report SPAM

Rupert,

I have a major apology/correction to make based on my comments above. It seems that Buffett was indeed behind the airline stock purchases after all, as disclosed in the new Charlie Rose interview. It's hard to believe based on everything he has said about the sector:

http://www.marketfolly.com/2017/02/warren-buffetts-interview-with-charlie.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+MarketFolly+%28Market+Folly%29

This is a feather in Bill Miller's cap.

brinchinn
Brinchinn premium member - 7 months ago

Consolidation of the industry is one obvious attraction - the top 4 airlines owning 84% in 2015 v.s 65% in 2010.

Perhaps also Trump's protectionist approach and inshoring of US interests are expected to increase domestic flights?

use13usa
Use13usa premium member - 7 months ago

An agreement between the U.S. and Mexico that took effect Aug. 21 [2016] will drop restrictions on the number of airlines that can fly between the two countries... Maybe this is one of the reasons for Buffett to buy into airlines. Link to the story: http://www.latimes.com/business/la-fi-travel-briefcase-mexico-20160827-snap-story.html

But most likely, Buffett's bet on airlines must have been related to Trump meeting with the CEOs of the US carriers.

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