Warren Buffett recently admitted that buying huge stakes in the airlines was a big mistake – 30 years after making a similar mistake with an airline. Those two wrongs certainly don’t make a right. However, his decision to bail on his stakes, as devastating as his losses were, was absolutely the right decision.
When the Oracle of Omaha makes a mistake, and he has made a few, it’s headline news. That’s because people want to think of Warren Buffett, arguably the most successful investor in modern history, as infallible. How else does one become one of the wealthiest people in the world? However, when Buffett makes mistakes, they tend to be whoppers, resulting in losses in the hundreds of millions or billions of dollars. But, if you had $125 billion sitting in cash on top of a $700 billion portfolio, you could afford to make a few mistakes.
In April, Buffett unloaded 100% of his stakes in the “big four” airlines – Delta (NYSE: DAL), Southwest (NYSE: LUV), American (NYSE: AAL), and United (NYSE: (UAL), after the entire industry crumbled amid the pandemic crisis. Not one to fully explain his investment moves, he told his shareholders at the annual Berkshire Hathaway meeting, “I just decided that I made a mistake.”
Fool Me Twice
While his exit from all his airline positions was big news, some would argue that his across-the-board stock purchases of the major airlines a few years ago were even bigger news. This was the same Warren Buffett who swore off airlines following his U.S. Air fiasco more than 30 years ago. In 1989, he bought preferred stock U.S. Air based on its record of revenue growth it had achieved up to that point. What Buffett failed to realize is that revenue growth was only possible because U.S. Air was loading up on debt to finance the new planes necessary to continue that growth. Very soon, the airline couldn’t afford to pay the dividends due on its stock. Buffett quickly sold his position, and, fortunately, he did so at a profit.
Buffett learned his lesson (as he usually does) and vowed never to invest in airlines again (until he did again 30 years later). In a letter to his shareholders, Buffett acknowledged that sometimes a business looks good in terms of revenue growth only to require significant capital investments to achieve that growth. He knew then that, to achieve a large earnings base, capital intensive business models are often heavily laden with debt, which leaves little for shareholders, and leaves the company vulnerable to financial shocks.
Soon after his fiasco, he wrote to his shareholders about his mistake, saying, “Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. Buffett proved to be as fallible as any other investor by confusing revenue growth with a successful business.
Never Say Never
Fast forward 25 years. After more than a decade of stagnant growth, bankruptcies, and multiple mergers, the airline industry seemed to turn things around, recording record revenues and profits. This caught Buffett’s attention, and, almost unbelievably, he invested more than $4 billion to acquire a roughly 10% stake in the major airlines. He was banking on the idea that people would be flying more than ever, and the carriers would maintain their value while continuing to buy back their shares. We now know how that worked out.
What’s remarkable about Buffett’s investment decision is that, fundamentally, nothing had changed with the airline industry. As a result of some overhauling of their business models, increased efficiencies, and the introduction of new fees, they did regain their profits. However, beneath the surface, they are still highly capital intensive, and their revenue growth will always be dependent on debt to finance new aircraft. But, compared with where these airlines were more than ten years ago, their revenue growth, up and until the pandemic, was alluring.
Know the Story Behind the Growth
Obviously, Buffett’s decision to sell was the right one, and he was wrong to invest in the first place. As he has acknowledged in the past, when he makes a mistake, he doesn’t take half measures to correct it. He sells it all and moves on to the next investment. Since he exited his airline positions in April, airline stocks have continued to slide, and their outlook in the face of a distressed economy is not good.
As I wrote in my last blog post, When Decisions Not to Buy Can be as Profitable as Decisions to Buy, no one, not even Warren Buffett, could have known that a sudden pandemic would obliterate the airline industry. You certainly can’t fault the airlines. And, it’s difficult to fault investors who were riding a rare wave of airline stock growth.
But that underscores the importance of having an investment process you can trust. The best investment decision any investor could have made was to avoid airline stocks based purely on the fundamentals.
In that article, I referred to one of the better investment decisions I’ve made when I decided not to buy Southwest Airlines stock in 2018. While I was never a big fan of airline stocks, Southwest was intriguing for its earnings growth over the prior ten-year period. Of course, that’s always the allure for investors – growth.
But, after running it through our framework, it only matched two of our five criteria, and its mounting debt was concerning. So we passed. While we didn’t review the other airlines, we doubt we would have invested in any of them, even though they were enjoying their greatest stock growth in years.
In hindsight, we were wise to stay away, but I certainly wasn’t any more prescient than Buffett. No one could have foreseen the events that are occurring. However, recognizing the underlying risk of mounting debt – with Southwest and all the airlines – it was clear that these companies would not fare well in any economic contraction.
