US airline stocks:
Not Trumped but Buffetted November 2016

President Trump’s election came as a bit of shock, but the US airline industry — in contrast to the British reaction post-Brexit when European airline shares slumped both absolutely and relatively — has responded with equanimity.

In fact as the graph below illustrates, the market dismissed any uncertainty that the radical presidential choice has caused; all the major US airline stocks moved up following the election result, continuing the general trend for strong growth over the past five years.

Aviation policy did not figure prominently, if at all, in Trump’s unconventional campaign, but it is possible to make a positive case (purely from the US industry’s perspective). First, if the election promises are followed, there will be a massive increase in government spending on infrastructure at the same time as corporate and personal taxes are slashed, which — if (a rather big if) all the economic and fiscal multipliers align correctly, and investors, including presumably the Chinese, are willing to buy US infrastructure bonds — could mean that GDP growth will be substantially boosted, doubled according to Trump’s claim. Second, US foreign policy is now protectionist, again interpreting from the campaign rhetoric. This presumably means that US carriers will be more protected from “unfair” competition from the Middle East superconnectors and pesky new entrants like Norwegian.

More fundamentally, there appears to have been a fundamental shift in the investment community’s attitude to the main US airlines, which has been brought into prominence by a decision by Berkshire Hathaway (BH), the Omaha based investment fund/insurance company/industrial conglomerate headed by Warren Buffett, whose very investment moves are obsessively monitored in the hope of replicating his consistent financial success.

In its recently filed Form 13F, BH revealed an investment of $0.8bn in American, $0.25bn each in Delta and United, plus, a little later, a further purchase of an estimated $0.25bn in Southwest — about $1.55bn in total, which is about 1% of the BH’s share portfolio.

This is interesting because Warren Buffett was perceived to be vehemently anti, when it came to airline stocks, following a painful investment in USAirways in the early 90s. Commenting in Berkshire Hathaway’s always entertaining annual report, Buffet said at the time: “As for the future performance of the airline industry, your guess is as good as mine. Actually, given my record with USAirways, your guess will be better than mine.”

He also joked to a group of business school students, “I now have an 800 number I call every time I think about buying a stock in an airline. I say, ‘I’m Warren and I am an air-aholic.’”

But that is not the full story. BH held on to USAirways convertible preferred stock which became very valuable when CEO Steven Wolf started to deliver financial success at the carrier in the late 90s, and the share price soared. By the end of the decade Buffett was able to write that his airline investment record was no longer “unblemished by success” and that the “USAirways shares will produce a decent profit — that is if my cost for Maalox is excluded.” [for non-US readers, Maalox is an over-the-counter indigestion medicine].

BH has also been the sole owner of NetJets for the past 20 years, a decision made by Buffett because his own experience of the fractional ownership operation was so good.

Now US airline stocks have been accepted into the BH portfolio, it is worth asking the question: why is BH deemed so important? Under the charismatic but self-deprecatory Warren Buffet, BH has achieved a stock market valuation of $390bn, and generated a roughly 20% annual average increase in value since the 1960s (when he joined BH, it was primarily a declining textile company). The core business is insurance which provides the “float”, premiums paid up front, for investment either directly in wholly owned companies or into major stakes in publicly quoted companies, mostly American but a few European. It’s a low cost method of obtaining investment funds.

BH’s aim, or rather raison d’être, is to achieve long-term value growth in its shares substantially above that of the S&P500 (otherwise, as Buffett points out, investors would be better off with a low cost tracker fund). These are some of the, deceptively simple, principles that BH applies:

• BH does not play industry cycles (which is what investors have mostly done with airline stocks) but always invests with the aim of holding for the very long-term, although recessions are regarded as increasing buying possibilities.
• Share purchases are made using the same criteria as BH uses when buying companies — strong franchises, consistent long-term growth prospects, quality management that are dedicated to the company (BH never imposes its own managers).
• BH likes strong brands; its portfolio includes Coca-Cola, Amex, Wells Fargo, Phillips, Wall Mart, etc.
• BH’s aim is to buy the right company at the right price, but even if it buys the right company at a wrong price that should ultimately sort itself out because of its long-term holding strategy; however, it should never buy the wrong company at what appears to be a bargain price.
• BH finds comfort in industries where there isn’t or doesn’t appear to be a threat from disruptive new technology — commercial aviation mostly fits this criterion.
• Conversely, BH does not generally invest in new technology, leaving that to those who understand such things; notably BH refused the temptation to invest in dotcoms during the early 2000s boom, was criticised for undeforming the stockmarket but was quickly vindicated when the bubble burst.
• The obvious change that has brought the US airlines into BH’s universe is the massive consolidation that has taken. As the result of AA/US, UA/CO and DL/NW the four biggest US airlines (Southwest being the fourth) now control 76% of the total US industry (measured in RPMs) compared to 55% ten years ago. As a result, the big four are producing the sort of results that appeal to BH: in 2015, $122bn of revenues, $23.3bn of operating profits (23% margin) and combined net profit of $21.7bn (18%).

Significantly, it appears as if this performance is sustainable in the long run, though the business cycle has not gone away and there are always external events, because the industry is being very moderate in increasing capacity, concentrating on unit revenue improvements and not entering into destructive market share wars. What is rather less clear is whether the financial gains will eventually leak back to labour, and whether one or more of the smaller low cost carriers might be able or willing to aggressively take on the big four, and challenge the status quo.

Ownership consolidation by cross-holding funds

While the US operational consolidation is obvious, there has been another development which might be of equal or even greater importance — a remarkable degree of ownership consolidation, identified in an analysis in the Harvard Business Review (HBR, November 2016). The table, below, compiled from data in the HBR report, shows that seven huge investment funds, of which BH is the latest and smallest, have each accumulated cross-holdings in all four of the US largest airlines.

Their joint shareholdings range from $7.3bn in United, $7.4bn in Delta, $10.4bn in American to $11.1bn in Southwest — $36.1bn in total or about 32% of the current market capitalisation of the four airlines. This gives the crossholding funds substantial control over the core US industry, and actual control is probably greater still as the HBR estimates the percentage of voting shares held by the seven funds to be well over 40%.

From a shareholder’s perspective, this is generally very good news; not only does it demonstrate great confidence in the sector, it also acts as a block to excessive competition or destructive fares wars. The funds are not backing one airline but all four, so an aggressive expansion might be successful and enhance that airline’s value but it would damage the others — a zero sum game for the funds. The funds can exercise control passively, just through the weight of their shareholdings, or more actively, through for example, signalling to Wall Street analysts, whose coverage of US airline stocks appears at times to be obsessed with projecting ASM and RPM trends, and issuing calls for “capacity discipline” when the former exceeds the latter.

From a passenger perspective, the industry and ownership consolidation is perhaps not such good news. It implies a collusive industry characterised by strengthening unit revenues, which means rising fares, uncomfortably high load factors and restricted service on thin routes. Wealthier business travellers might then be tempted to try out NetJets’ fractional ownership product — clever man, that Warren Buffett.