In his latest letter to investors of the Pabrai funds, manager Mohnish Pabrai (Trades, Portfolio) declared that he only owned two U.S. stocks: Fiat Chrysler (FCAU, Financial) and Southwest Airlines (LUV, Financial).
Pabrai is considered by many to be one of the world’s best and most intelligent value investors. So it’s interesting that he would own these two stocks and nothing else.
In an earlier article, I covered Pabrai’s investment thesis for Fiat, what he liked about the stock and what he believes the company is worth over the long term. There is extra focus on the skill of management.
In this article, I’m going to cover Pabrai’s investment thesis for Southwest, what he likes about the company and where he sees the stock going.
Love-hate industry
The airline industry has attracted plenty of attention recently because Warren Buffett (Trades, Portfolio) has bought large stakes in four of the most prominent U.S. carriers. Buffett bought because he believes that the industry has now changed for the better. Capital discipline and consolidation has altered these companies from basket cases into top-quality investments, and it seems Pabrai agrees, as he told Barron’s in an interview last year:
“So why did Berkshire (BRK.A, Financial)(BRK.B, Financial) buy into this really crappy industry? I believe they think the industry has changed, just as the auto industry has changed. I don’t know if you’ve been on a flight lately, but there are no empty seats. The load factors are through the roof.”
He went on to say that, with the shale oil boom, airlines’ most significant cost – fuel – is suddenly one of the most considerable tailwinds.
“We aren’t going to see high oil prices, pretty much ever, because if oil goes to $60 a barrel, they will start pumping in West Texas. The fracking companies can be profitable in some parts of Texas at $35-a-barrel oil. So oil, for any sustained period, isn’t going to go up.
“Airlines benefit because of the costs. They have huge load factors, very cheap fuel, and most of the competitors are gone. There is also a monopolistic aspect to these businesses depending on where a customer lives. If you live in Dallas/Fort Worth, you will fly American (AAL, Financial), and if you are in Newark, New Jersey, you will fly United (UAL, Financial), because they dominate there. The airlines aren’t exactly commodities because in certain parts of the country, different ones dominate. The dominant ones in that place have pricing power.”
Wider margins coupled with less competition is good news:
“There are elements of the business that are good. But they were overshadowed by the bad. Fuel is volatile; labor relations were volatile. And they had too many competitors. Now, from a dozen airlines or more, they are down to four or five.”
It’s reasonable to suggest that Buffett is attracted to the same qualities. But unlike Pabrai, Buffett bought the whole industry –Â he’s diversified whereas Pabrai has concentrated all of his bet on just one company.
Such a concentrated position might seem risky, but Pabrai chose Southwest due to its best-in-class culture, as he told Barron’s:
“I like their culture the most. They are all cheap, but Southwest has the best culture. I think it was The Wall Street Journal that did an article on Delta Air Lines (DAL, Financial), United Continental Holdings and American Airlines Group, showing that cabin interiors for all three are now the same. They’re all shades of gray and blue. So these three are becoming clones of each other.”
In another interview with Forbes earlier this year, Pabrai added some color to this statement:
“Southwest has an unusual culture. They do not allow any type of art on the walls of their headquarters. Instead, they only allow pictures of the employees’ friends and family. When Southwest hires, they are far more concerned with the psychological makeup of the person than his or her capabilities. They believe they can teach capabilities but cannot change psychology. I feel happier riding coach on Southwest than flying business on American or United. I do not know why that is, but the thing is, Southwest is a happy place. They have hired a certain type of people that have the freedom to make the aircraft a happy place. Other companies have tried to copy Southwest, but they could not make it work because it is almost impossible to clone their culture.”
Arguably, this is one of the best reasons to buy a company: culture. If Southwest has a better culture than its peers, it should be able to retain and attract customers, increase prices and perform better than average.
The company’s latest earnings release, published earlier this week, showed the effect of this attention to culture.
Southwest reported a profit of $503 million, or 84 cents per share. That was up sharply from a year-ago net of $388 million, or 62 cents per share. Revenue rose 2.6% to $5.3 billion for the quarter as unit revenue increased 1.5%.
All in all, Southwest is a company with a great culture in an industry that’s benefiting from several strong tailwinds. The company also looks cheap. Right now the shares are trading at a forward P/E of 12.6 and EV to EBITDA ratio of 7. For a company that generated a return on capital employed of 22.9% last year, these metrics undervalue the business.
Disclosure: The author owns no share mentioned.
