Even before the coronavirus, we were not big fans of the airline. Airplanes are expensive. Airlines must pay for them whether they are fully occupied during normal economic times or when they are half-loaded in recession. Their other major cost is fuel – airlines have little control over it. If they secure the oil price and it goes up, they are heroes. If they secure oil and it declines, their unsecured competition will have an economic advantage. Developing competitive advantages is very difficult; Customers usually have very little loyalty and price is the deciding factor for most purchasing decisions.
Airlines were never our cup of tea. The high fixed cost structure in the industry and its past history of going bankrupt every other recession made our EQ in terms of 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 the rare benefits) and must own our decisions, so we gave the airlines without spending much time thinking about them.
When you go into recession, you can look at the rear-view earnings for a cyclical company, and it becomes your target for future earnings power in a year or two, max. We do not know how long it will take until we again see the revenue power in 2019 for airlines and the travel industry in general. This is what we know. Although it is difficult to imagine this today, the fear of COVID-19 will eventually disappear, either because it is a vaccine or a cure, or because the virus is gone, or because we simply want to adapt to its existence.
But even in the absence of a vaccine or cure, we will change our behavior, and it will happen slowly on the margin. After being locked up for a few months and not seeing friends and relatives, except on Zoom or Facetime, we visit their homes and sit six feet apart on their porches. (My family did this on Mother's Day.) Then we would invite very close friends – those who stayed religiously to social distance – to our homes for dinner. Then we might chance to visit a restaurant with outdoor seating. Then, on a rainy day, we enter the restaurant and find that it now has a huge distance between the tables. We make many small step-by-step decisions; each will be a small compromise that will push us out of our fears.
Of course, every time we read about severe virus flare-ups, we take one step back.
Flying is at one extremity in the spectrum of social distance. It requires finding the way through airports packed with people and then recovering on a plane that, even after removing the middle seats, will still have a higher density than a full bar Friday night in Manhattan. So flying will require many small, incremental, marginal decisions before we overcome the fear of boarding a plane.
Vaccine availability would immediately overcome fear, and our behavior would return to normal. Well, almost. There will be scar tissue on the economy – trillions in government debt and sustained high unemployment – that will take time to clean up. People don't fly today because we're in lockdown; they will fly less than they used to after the lock is over because they are still afraid; and after their fears are gone, they will still fly less because they cannot afford the air travel.
We imagine that when Buffett bought airlines in 2015, he thought the worst case would be a significant recession where the investment would fall from the usual 80-90% to 50-60% (according to FT, there are only four airlines of a few hundred that are profitable with 62% occupancy). His thinking was that airlines would lose some money in some quarters, but the recession would be anything but an existential crisis for them. The recession in recent months and the expansion years, and he believed that he had bought them cheap at full entrance (both recession and expansion).
Despite being Oracle of Omaha, he did not foresee that one day we could have another type of recession where 95% of planes would be grounded, not because people could not afford to buy tickets, but because they would be required to stay home by their governments, or would be afraid that closeness 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 that must be paid for whether they use it or not.
The sad reality is that unless the airlines raise new capital, they will go bankrupt. Although this capital can save them, it will reduce the value of the companies. Issuance of shares, especially at today's depressed stock prices, will dilute shareholders permanently, as future earnings will be shared with a much increased shareholder base.
If the airlines issue debt, it will also not be cheap capital and will charge these companies, which already have many fixed costs, at a different cost – significant interest payments that will significantly reduce their future earning power. The longer the fear of the virus persists, the more money these companies will lose, and the greater the damage that will be done to their balance sheets and thus their future earning power.
When we think of the virus, we have three timelines. , or epochs: BC – before coronavirus, DC – during coronavirus (now), and AC – after coronavirus (the virus is completely gone, or it is a vaccine or effective treatment). The longer the DC era lasts, the more impact it will have on the AC era. The DC era has high unemployment and huge government spending – larger deficits and an ever-growing debt high that are no longer counted in billions but in trillions.
The future of 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 spend 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 to die so I don't get there." So it is worth having a clear picture of what types of businesses you do not want to own.
Second, we wanted to point out Buffett's ability to change his mind. Interestingly, Buffett, already the largest shareholder in US airlines, bought several airlines a few weeks before selling them. We did something similar in the quarter as well: We increased our position in Melrose Industries (OTC: MLSPF), only to sell the entire position two weeks later. (More on Melrose to follow).
Third, we, like Buffett, played traditional chess, and did not realize that the game had changed to Fischer's random chess. We followed the normal recession manual (mental models), but then realized that this is anything but a normal recession. We have to be incredibly careful about using our mental models today; they were built in a very different environment. Today, past experience is not useless, but if you depend on it blindly it can be dangerous. Some things will play out in the future as they have done in the past, but many do not.
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 didn't know anything, and instead of continuing to think analogously, we began to question every assumption we make in our analysis.
Our decision to sell Melrose Industries is very similar to Buffett's sale of airlines. We sold Melrose before the annual meeting in Berkshire Hathaway. It was a difficult decision, not because we cemented losses, but because we went away with a business we really liked, which was run by good management, and which was significantly underestimated when we bought it.
When we bought Melrose, we stress-tested it for a severe recession; The decline that Melrose is likely to experience today did not occur to us in our wildest imagination. Melrose is a very strong player in two industries that has been hugely affected: the airline's space (it makes parts that go on planes and engines) and car parts (it is one of the largest manufacturers of transmissions for cars). We talked to the company. It has credit lines and cash to give it immediate liquidity, but we're not sure if that will be enough.
We had used the traditional recession model in our analysis, and we were wrong. Given the world we're looking at now, we should have sold it sooner.
Buying new aircraft is the latest in airlines today. In addition, only 20% of Melrose's business comes from spare parts. Melrose's auto parts business (ironically, the business we were most concerned about when we bought the stock) might be fine; it can even make some profit; but we are not sure it will be able to sustain the company. We simply do not know what the losses will be in the airline's space and for how long. We have tremendous respect for the Melrose management team – they are a big reason why we bought the stock – but at this point the problem that Melrose faces is greater than them.
If you look carefully through your portfolio, I see that we have placed it on the opposite side of the spectrum from the airlines. Most of our holdings are concentrated in four industries: defense, healthcare, tobacco (where we are allowed by clients) and telecommunications. These industries have one thing in common: They will not be structurally affected 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 price strength – in the event of deflation, they will maintain prices, while they will raise them during inflation.
And one more thing …
I'm not a journalist or reporter; I am an investor who thinks through writing. This and other investment items think only at the time they were written. However, investment research is not static, it is fluid. New information comes our way and we continue to research, which can cause us to adjust and change conditions and thus change our minds.
We are long-term investors and often hold shares for many years, but as luck may or may not have, after reading 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 such as learning and thinking frameworks. But these are not investment recommendations. The main point is this. If this article gives interest to the company I mentioned, good. This should be the beginning, not the end, of your research.
Originally published on ContrarianEdge.com
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