Warren Buffett hates the airlines industry. Oh yes, it’s true. The story began in 1989 when Buffett, as the Chairman of Berkshire Hathaway, decided to invest US$360 million of the firm’s cash into preferred shares of airline operator USAir. At the time, it looked like a pretty sweet deal. Shares of the airline offered a 9.25% dividend. Buffett praised Ed Colodny, USAir’s CEO, as one of the select few that Berkshire “likes, admires and trusts.” But USAir ran into severe problems right after Buffett invested in the company. The economics of the airline industry quickly deteriorated. A year later, Buffett admitted…
Warren Buffett hates the airlines industry. Oh yes, it’s true.
The story began in 1989 when Buffett, as the Chairman of Berkshire Hathaway, decided to invest US$360 million of the firm’s cash into preferred shares of airline operator USAir. At the time, it looked like a pretty sweet deal. Shares of the airline offered a 9.25% dividend. Buffett praised Ed Colodny, USAir’s CEO, as one of the select few that Berkshire “likes, admires and trusts.”
But USAir ran into severe problems right after Buffett invested in the company.
The economics of the airline industry quickly deteriorated. A year later, Buffett admitted that the airline industry’s problems have proven to be far more serious that he had anticipated. Airlines sell a commodity product, he mused, and it was tough to pull ahead when your competitors are drastically cutting prices. In summary, he said:
“The trouble this pricing has produced for all carriers illustrates an important truth: In a business selling a commodity-type product, it’s impossible to be a lot smarter than your dumbest competitor.”
As he licked his wounds, Buffett conceded that the firm’s investment in USAir had become far less secure a year after the investment was made.
From Bad to Worse
But it got worse. Colodny stepped down in 1992, and the bottom fell out for the airline industry. Three airlines, Midway, Pan Am and America West, all filed for bankruptcy. In the same year, Buffett delivered a damning assessment of the airline industry:
“Despite the huge amounts of equity capital that have been injected into it, the [airline] industry, in aggregate, has posted a net loss since its birth after Kitty Hawk.”
(Note: For the non history buffs, Kitty Hawk is the location where the Wright brothers completed its first aircraft flight.)
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The Day of Reckoning
In 1993, another two airlines fell into bankruptcy. In the same year, Buffett was asked to join the board of directors at USAir. He agreed.
But there was no happy ending for this story.
A year after he joined the board, USAir suspended its dividend. In 1994, Buffett finally threw in the towel. He said that he will be stepping down from the USAir board of directors. At the same time, Berkshire wrote off 75% of its holdings in the company.
As you can see, Buffett has every reason to hate the airline industry.
It’s been long-standing grudge against the industry. During Berkshire’s 2013 annual meeting, Buffett fired perhaps his most famous “kill-shot” at the industry:
“Investors have poured their money into airlines and airline manufacturers for 100 years with terrible results. It’s been a death trap for investors.”
And by the way, did I mention that Buffett hates airlines? No, scrap that. Buffett really, REALLY hates airlines.
Defying the Oracle of Omaha
But Buffett is not the only money manager in Omaha. Some believed that airline companies are worth investing in.
In 2016, an Omaha firm quietly started buying shares of the largest airline operators in the US. By the end of that year, the firm had sunk at least US$5.5 billion into airline stocks. But it was far from done. The firm continued pour billions into airline stocks into 2017, pushing its holdings to almost US$10 billion as we speak.
Surely, Buffett wouldn’t approve of such a reckless endeavour.
But the firm was run by an investor that had made quite a name for himself. For a period of over 50 years, the firm had grown its book value by 19.1% per year. His track record was nothing short of remarkable, given that it is more than two times the annual returns of Singapore’s Straits Times Index (SGX: ^STI).
The investor was well known by another nickname—the Oracle of Omaha.
Yes, this investor is the same Warren Buffett who had called the airline industry a disaster for investors. And yet, Berkshire had poured billions into an industry that he had disdained for decades.
Will the Real Warren B Please Stand Up
At the face of it, it is easy to think that it is pure hypocrisy for Buffett to be investing in airlines. After all, he called the whole industry an investor’s death trap a mere five years ago.
A. Death. Trap. Let that phrase sink in for a moment.
Based on Buffett’s excruciating experience with USAir, the lesson seemed clear: avoid airline stocks like the plague. Except that’s not the lesson for investors.
In 1994, Buffett reflected on his flawed decision to invest in USAir. Prior to 1978, the airline industry was protected by regulations. As such, airline operators were under no pressure to manage costs. In Buffett’s own words:
“In earlier years, these life-threatening costs posed few problems. Airlines were then protected from competition by regulation, and carriers could absorb high costs because they could pass them along by way of fares that were also high.”
The airline industry was deregulated in 1978. High-cost airlines continued to operate the way that it had prior to the deregulation. Slowly but surely, low-cost carriers started to expand its capacity to serve more routes. Buffett mused that the problems were slowly creeping up, but ignored until it was too late.
The day of reckoning would eventually arrive.
Low-cost operators started to force the old, high-cost operators into cutting its costs that had been become embedded for years. Faced with the threat of loss, the high-cost operators (USAir included) struggled to come to terms with the new, lower cost environment. Buffett concluded in 1994:
“In an unregulated commodity business, a company must lower its costs to competitive levels or face extinction.”
Buffett owned up to his mistake in 1994. But he also went one step further to understand the conditions that led to his mistake. By reflecting on his error, I would argue that Buffett set himself up for success later down the road.
When the conditions that led to his failed USAir investment changed, Buffett was able to recognize it—in my view.
In 2015, the big four airlines—all of which Berkshire now owns—controlled 80% of seats and flights in the US. As the airline industry consolidated to less than a handful, the kamikaze-like pricing tactics of the past faded away in favour of a keen focus on profits.
While the airline industry still had its flaws, today’s operating environment is very different from 1989, when Buffett made his first foray into airline stocks. It would be fair to say that condition has changed enough for Berkshire to sink billions into the industry once again.
Learning the Right Lessons
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Editor’s note: A version of this article first appeared in the 3 April 2018 edition of Take Stock Singapore.
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Disclosure: The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chin Hui Leong own shares in Berkshire Hathaway.