Is there a change in the air for airline investing?
A high cost of labour, fluctuations in the fuel price and heavy reinvestment have made airlines deliver notoriously bad long-term returns. Generating free cashflow in particular tends to elude the sector.
So when an airline stock highlights well under our initial investment screens, I always joke with myself that how can I – as a mere mortal fund manager – buck the bad luck trend set by Warren Buffett with his terrible experience investing in US Airways, or the mythical Gordon Gekko, whose undoing in the movie Wall Street was his investment in Bluestar Airlines?
Investors are justifiably sceptical about airlines given their track records. Like extremely economically sensitive companies in the semiconductor, automobile and chemical sectors, there have been times to ‘rent’ rather than own the stocks as they emerge during periods of recovery.
They do not persistently create value for shareholders as periods where they have a competitive advantage are usually quite short.
However, we may be witnessing signs of a transformational restructuring that will enable them to become profitable for a prolonged period of the business cycle and that will make them suitable investments over many years. This would allow shareholders to stay invested as owners rather than renters of the stocks.
Given the continuing economic woes in Europe and deceleration in the rate of change in the still growing US and emerging market economies, the best strategy to employ on investment portfolios is currently a barbell one, comprised of at least one half leading mega-cap blue-chip stocks with attributes that render them undervalued based upon the multiples at which their shares now trade. These companies, whose fundamentals will stand out increasingly as the business cycle matures, will distinguish themselves from the broad market through organic growth from innovation and pricing power. Companies such as Apple, Caterpillar, Google and Starbucks typify these attributes.
For the other part of the barbell, there remain many companies that continue to grow their earnings and took the initiative during the most recent recession to enhance operations by streamlining labour forces and optimising assets. US companies, such as Textron and Harley-Davidson, typify these attributes, as do the two largest US airlines – United Continental and Delta.
In the past two years, we have seen Delta’s merger with Northwest and United’s merger with Continental to create United Continental. This has created two giant carriers whose combined share of the market is approximately 34 per cent. If US Airways combines with American Airlines as anticipated, the combined new ‘Big Three’ will have 53 per cent market share based on passenger miles flown – the highest concentration before industry deregulation several decades ago.
Following these mergers, carriers are cutting costs by grounding less fuel-efficient aircraft from their fleets and shedding unprofitable routes. This ‘wise contraction’, as well as a tougher approach to airline operations, is translating into profits and the creation of wealth for shareholders. For airline customers, this wise contraction by the airlines likely means fewer cheap deals.