Even before the coronavirus we were not big fans of
the airlines business. Planes are expensive. Airlines have to pay for them
whether they are fully occupied during normal economic times or when they are
half-loaded during recessions. Their other big cost is fuel – airlines have
little control over it. If they hedge the oil price and it goes up, they are
heroes. If they hedge oil and it declines, their unhedged competition will have
an economic advantage. It is very difficult to develop competitive advantage;
customers usually have very little loyalty and price is the deciding factor for
most buying decisions.
Warren Buffett invested in the airlines industry in the ’80s, lost money, and
swore he’d never invest in it again. However, after the Great Financial Crisis
the industry went through significant consolidation by mergers and attrition,
leaving four carriers controlling the bulk of the market. Fewer competitors
made competition more rational and turned these airlines into much better
businesses. So Buffett changed his mind and bought a 10% stake in all four of
the largest US airlines. For a few years it seemed that he was finally right
about the airlines.
Airlines were never our cup of tea. The high fixed-cost structure of the
industry and its past history of going bankrupt every other recession made our
EQ when it comes to airlines very low. When Buffett bought them, for some value
investors, the airlines had been blessed by the high priest. We are agnostic
(growing up in Soviet Russia has its rare benefits) and have to own our
decisions, so we passed on the airlines without spending much time thinking
about them.
Typically, when you go into recession you can look at the rear-view mirror
earnings for a cyclical company and that becomes your goalpost for future
earnings power within a year or two, max. We don’t know how long it will take
until we’ll again see the 2019 earnings power of airlines and the travel
industry in general. Here is what we know. Though it is hard to imagine this
today, 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.
But even in absence of a vaccine or cure, we’ll change our behavior, and that
will happen slowly on the margin. After being locked up for a few months, not
seeing friends and relatives except on Zoom or Facetime, we’ll timidly visit
their houses and sit six feet apart on their porches. (My family did this on
Mother’s Day.) Then we’ll invite very close friends – the ones who stuck
religiously to social distancing– to our homes for dinner. Then we might chance
visiting a restaurant with outdoor seating. Then, on a rainy day, we’ll go
inside the restaurant and find that it now has huge spacing between the tables.
We’ll make a lot of small incremental decisions; each will be a tiny compromise
that will nudge us out of our fear.
Of course, each time we read about serious virus flareups, we’ll take one step
back.
Flying is at one extreme in the spectrum of social distancing. It requires
finding your way through airports packed with people and then getting on a
plane that, even after the middle seats are removed will still have a higher
density than a packed bar on Friday night in Manhattan. Thus flying will
require a great many little, incremental, marginal decisions before we overcome
the fear of boarding a plane.
Vaccine availability would instantly vanquish fear, and our behavior would come
back to normal. Well, almost. There will be scar tissue on the economy –
trillions in government debt and persistently high unemployment – that will
take time to clear up. People are not flying today because we are in lockdown;
they’ll be flying less than they used to after lockdown is over because they
are still afraid; and after their fear is gone they’ll still be flying less
because they cannot afford the flights.
We imagine that when Buffett bought airlines in 2015, he thought the worst case
would be a significant recession where plane occupancy would fall from the
usual 80-90% to 50-60% (according to the FT, only four airlines out of
a few hundred are profitable at 62% occupancy). His thinking was that the
airlines would lose some money for a few quarters, but the recession would be
anything but an existential crisis for them. Recessions last months and
expansion years, and he thought he had bought them cheap on full-cycle (both
recession and expansion) earnings.
Despite being the Oracle of Omaha, he did not foresee that one day we might
have a different type of recession where 95% of the planes would be grounded,
not because people couldn’t afford to buy a tickets 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.
Very 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.
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, especially at today’s depressed stock
prices, 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 virus 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: BC – before
coronavirus, DC – during coronavirus (now), and AC – after coronavirus (the
virus is completely gone, or there is a vaccine or effective treatment. The
longer the DC era lasts the more impact it has on the AC era. The DC era comes
with high unemployment and enormous government spending – larger deficits and
an ever-growing debt pile that is no longer counted in billions but in
trillions.
The future of 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).
We don’t own airlines, so why am I spending so much time talking about them?
There are several reasons. First, because they are companies that are
antithetical to our portfolio philosophy. Charlie Munger says, “Tell me where I
am going to die so I won’t go there.” So it’s worth having a clear picture of
the types of businesses you don’t want to own.
Second, we wanted to point out Buffett’s ability to change his mind.
Interestingly, Buffett, who was already the largest shareholder of US airlines,
bought more airline stocks a few weeks before he sold them. We did something
similar this quarter, too: We increased our position in Melrose Industries,
just to sell the full position two weeks later. (More about Melrose to follow).
Third, like Buffett, we were playing traditional chess, not realizing that the
game had changed to Fischer random chess. We were following the normal
recession handbook (mental models) but then realized that this is anything but
a normal recession. We have to be incredibly careful about using our past
mental models today; they were built in a very different environment. Today,
past experience is not useless, but if relied on blindly it can be dangerous.
Some things will play out in the future as they have in the past, but many
won’t.
We needed to start using a first-principles approach – a concept we shamelessly
borrowed from physics. We took out a blank piece of paper, assumed we knew
nothing, and instead of continuing to think by analogy, started questioning
every assumption we make in our analysis.
Our decision to sell Melrose Industries is very similar to Buffett’s sale of
the airlines. We sold Melrose before the Berkshire Hathaway annual meeting. It
was a difficult decision, not because we cemented a loss but because we parted
with a business we really liked, that was run by good management, and that was
significantly undervalued when we bought it.
When we were buying Melrose we stress-tested it for a severe recession;
however, the decline that Melrose is probably experiencing today did not occur
to us in our wildest imagination. Melrose is a very strong player in two industries
that have been impacted tremendously: the airlines space (it makes parts that
go into planes and engines) and car parts (it is one of the largest makers of
transmissions for cars). We talked to the company. It has credit lines and cash
to give it immediate liquidity, but we are not sure if it will be enough.
We had applied the traditional recession mental model to our analysis, and we
were wrong. Given the world we are looking at now, we should have sold it
sooner.
Buying new planes is the last thing on airlines’ minds today. Also, only 20% of
Melrose’s business comes from replacement parts. Melrose’s auto parts business
(ironically, the business we worried about the most when we bought the stock)
may be okay; it may even generate some profit; but we are not sure it will be
able to sustain the company. We simply don’t know what the losses are going to
be in the airlines space and for how long. We have a tremendous respect for the
Melrose management team – they’re a big reason why we bought the stock – but at
this point the problem that Melrose is facing is bigger than them.
If you look carefully through your portfolio, you’ll see that we’ve positioned
it to the opposite side of spectrum from the airlines. Most of our holdings are
concentrated in four industries: defense, healthcare, tobacco (where we are
permitted by clients), and telecommunications. These industries have one thing
in common: They will not be structurally impacted by the virus.
Consumption of goods and services in the four industries is completely
insensitive to the virus. These companies all have very stable cash flows and
pricing power – in the event of deflation they’ll maintain their prices, while
during inflation they’ll raise them.
And
one more thing…
I
am not a journalist or reporter; I am an investor who thinks through writing.
This and other investment articles are just my thinking at the point they were
written. However, investment research is not static, it is fluid. New
information comes our way and we continue to do research, which may lead us to
tweak and modify assumptions and thus to change our minds.
We
are long-term investors and often hold stocks for years, but as luck may or may
not have it, by the time you read this article we may have already sold the
stock. I may or may not write about this company ever again. Think of this and
other articles as learning and thinking frameworks. But they are not investment
recommendations. The bottom line is this. If this article piques your interest
in the company I’ve mentioned, great. This should be the beginning, not the
end, of your research.
Read
this before you buy your next stock
No comments:
Post a Comment