Why is Warren Buffett Investing in Airlines?

Berkshire Hathaway (BRK.A 0.97%) (BRK.B 1.16%) recently invested in four of America's largest airline companies -- seemingly going against Warren Buffett's often-stated distaste for any investment in the airline industry.

In this week's episode of Industry Focus: Energy, Motley Fool analyst Sean O'Reilly and Fool contributor Adam Levine-Weinberg explain why the company is finally investing in the industry, how much the investment has paid off so far, how investors should think about airline companies in light of this news, and more.

Also, the hosts briefly discuss the surprising news of OPEC's recent successful production cut. Find out how this move will affect oil prices, given the state of the industry today.

A full transcript follows the video.

This podcast was recorded on Dec. 1, 2016.

Sean O'Reilly: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, December 1st, 2016, so we're talking about energy, materials, and industrials. I am Sean O'Reilly and I'm being joined in studio by one of our veteran contributing writer analysts, Mr. Adam Levine-Weinberg. How's it going, Adam?

Adam Levine-Weinberg: Great, how are you, Sean?

O'Reilly: Not bad. I've had you on the show before, but you would Skype in. It's wonderful to see you in person.

Levine-Weinberg: It's nice to be here in the flesh.

O'Reilly: So, I've been at The Fool for a little over 3 years, and you have been not only one of my favorite fool.com writers, but one of the analysts that I trust the most, so I want to build you up a little bit for our listeners.

Levine-Weinberg: Thank you, I appreciate that.

O'Reilly: I asked you to join me here today because I wanted to talk about the surprising investments recently made by Warren Buffett's Berkshire Hathaway in the airline industry, which confounded me to no end. But before we cover this story, we have to talk about the big news of the week, which is OPEC actually pulling off a production cut. Did your jaw hit the floor?

Levine-Weinberg: A little bit. It seemed like it was going that way, but there were a lot of questions about whether OPEC would really get to a final agreement among its members, especially Iraq and Iran which were pushing back a lot on the idea that they would have to cut production.

O'Reilly: They were very publicly mean to each other at times. And I assume that's part of the negotiation process.

Levine-Weinberg: Yeah, it's part of the negotiation process, but you also have this problem where everybody in OPEC basically wants for OPEC to cut production, they just can't agree on who is going to do the cutting. Iran and Iraq would love for everybody else to cut production, because then they get to sell more at a higher price. The problem is, when you need to cut, unless it's spread evenly, then you have certain countries -- and in the past, it's usually been Saudi Arabia -- taking a lot of the brunt of lower production.

O'Reilly: Yeah. I remember when I was in high school economics class, talking about perfect competition and monopoly and all this stuff, and my professor talked about a cartel, and OPEC is the quintessential example. He was like, "You have every incentive to cheat." It doesn't make sense, because it would be like, if everybody just cuts production 2%, the price will double, and everybody wins dollar-wise. It is amazing to me how he was right.

Levine-Weinberg: Yeah. That's exactly true. Now, we should not, right now, assume that the price of oil is going to double. There are several factors --

O'Reilly: That was hypothetical, I apologize.

Levine-Weinberg: No, I see the point. Oil prices will, all things equal, go up. But there are some factors that are going to keep it down. First, you have really high inventories out there, because the past two or three years, everybody's been pumping way too much, at least a million barrels per day above what the actual demand has been. So, that's just all gone into storage. And even with this production cut it, it's probably going to take a couple of years to get inventories back down to a more normal level. On top of that, if oil prices go up by $10 or, especially if they go up by $20 a barrel, you're going to see a lot of activity by U.S. shale oil companies. In the past two years, they have been forced to cut their costs by a lot and become much more efficient. In 2013 and 2014 you would hear people throwing out $70 or $80 a barrel as break-even. A lot of these companies are making money -- not a lot of money, but they are making some money at $50 a barrel. If you see those prices go to $70, they're going to be back in the market in a big way.

O'Reilly: For sure. Those guys down in the Permian Basin, you look at the cost curves of these companies, since 2012, you kind of have to tip your hat to them. Bottom line, does today's news make you interested in any oil stocks?

Levine-Weinberg: Marginally. I think, if you're looking to get into the oil market, it's not a terrible time to start thinking about those companies, I would really focus on the best in class, lowest cost producers, because those are the ones that are going to be able to ramp up production while actually still making money, as opposed to, a few years ago, ramping up production and not making any money.

O'Reilly: Wouldn't that be nice, to actually make money? Before we move on to talking about Warren Buffett's recent investments in the airline industry, I want to briefly mention to our listeners that if you are interested in getting Industry Focus' top investing books, just email us at [email protected] with your own favorite investing book, and we will respond with our full list of the best books to improve your investing chops.

Adam, this is a slightly older store than I would prefer, we had the holidays and everything, but I immediately messaged you on Slack when this news hit the wires. Berkshire Hathaway owns shares of the four largest airlines. I recently turned 30, sorry to say --

Levine-Weinberg: It happens to all of us.

O'Reilly: Yeah, it happens to the best of us. I've been reading about Warren Buffett and investing for half of my life now. I wander into the library and I see these books, "Warren Buffett Way," and all that stuff, and all of them talk about, Buffett does invest in airlines. He's done it before, he gets burned. He did the preferred shares in US Airways. He always gets burned, and it is the quintessential example of a Warren Buffett mistake in that it's a commodity business. Then this hits the wires, and I just give up. I'm done. I'm just going to go quit and live on an island. What did you think? Give us some context, what's going on here?

Levine-Weinberg: I'd say, this news was much more surprising to me than the OPEC production cut.

O'Reilly: Boom, yeah. (laughs) 

Levine-Weinberg: Yeah. (laughs) Because, Warren Buffett really has, for a good 20 years now, warned off investors at every opportunity from airline stocks. Even when airlines have been profitable, he said forget it, they're not sustainable businesses, stay away.

O'Reilly: What's that quote? Had a capitalist who wanted to make money been at Kitty Hawk with Wilbur and Orville Wright --

Levine-Weinberg: He would have shot down the plane to stop the airlines.

O'Reilly: (laughs) That's kind of harsh, man.

Levine-Weinberg: It's harsh. What he was saying was basically, investors have found this allure in airline stocks for decades, and they have poured billions and billions and billions of dollars into the industry, and that's just money that's been lost, not money that has been invested. You look over the whole history of the airline industry, it has been unprofitable.

O'Reilly: And you're talking about the 90 year history.

Levine-Weinberg: Yeah. That's decades and decades. So, it's not a bad industry cycle, that's just been the business, for history. So, it was definitely surprising to see Berkshire Hathaway buy these airline stocks. Now, it's important to recognize that at this point, Berkshire is a really big conglomerate, Buffett does not control all of the investing. He has two lieutenants who invest most of the excess money that Berkshire Hathaway has. It's most likely that one of those two guys bought the first three airline stock --

O'Reilly: What's the position sizes of these things?

Levine-Weinberg: It's not that big. In total, the investment seems to be under $1 billion. That's a lot of money for you and I, but for Berkshire Hathaway that's small change.

O'Reilly: What do you mean, Adam? What are you saying? (laughs) 

Levine-Weinberg: (laughs) The first investments were in American Airlines, which is the largest position, then Delta Air Lines and United Continental. Those are the three biggest carriers, the remains of the legacy airline business. Those were probably not made by Buffett himself. According to Buffett, at least, he was at a conference or something, and Herb Kelleher, who's the founder of Southwest Airlines (LUV 1.41%), was there, and they're old friends, so they got to talking, and Buffett got back and kind of felt bad that they'd invested in three out of four and not Southwest Airlines, so he was like, "Let's buy some Southwest Airlines, too."

O'Reilly: Oh, no. Is that what Buffett's doing? Has he been doing this for the last fifty years, and I just don't know it?

Levine-Weinberg: Hopefully not.

O'Reilly: Is that what he's been doing, and he's just been really lucky?

Levine-Weinberg: I just think, in this case, it was a small amount of money and he felt like --

O'Reilly: He didn't care, yeah.

Levine-Weinberg: -- if his guys thought the other three were good investments, he figured, why not Southwest as well.

O'Reilly: Really quick side note, I want to get your thoughts, I'm sure you're aware that another brilliant investment manager, David Tepper, he runs Appaloosa Management, he's personally worth $10-11 billion. Not bad. He made a bunch of money buying the airlines right after the Great Recession, but not immediately --

Levine-Weinberg: He was really early.

O'Reilly: Like 2010. He made almost three times his money on American, at least. I wanted to know what you thought about that, and why is Buffett late to the game on this, what's going on?

Levine-Weinberg: I think, Buffett obviously was late to the game because he had this long-standing position.

O'Reilly: Bias, we'll call it bias for now. (laughs) 

Levine-Weinberg: Alright, let's call it a bias, against airlines. He'd said, several years ago ... I'll get the quote here, this is from the 2007 Berkshire Hathaway investor letter. "The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines."

So, he just saw these businesses as constantly wanting to grow, growing so fast that they need to buy lots of planes. Planes cost tens of millions of dollars, in some cases, over $100 million apiece. And after they spent all this money to get started, they wouldn't actually make money in the long run.

O'Reilly: You're subject to the vagaries of ticket prices --

Levine-Weinberg: And OPEC.

O'Reilly: Or OPEC, yeah.

Levine-Weinberg: Yeah. It's demand, it's oil prices, it's whether you have labor troubles, almost all of these airlines have a high percentage of their workers that unionize, and every time you start to make money, the unions say, "We want a bigger share of the profits." And to some extent, the airlines have to give in. They're customer service businesses. For a couple years, they can push back, but they can't have dissatisfied workers for a really long time or it's going to start to have a major impact on their profit, either way that they go. Anyway, I think Tepper obviously saw much earlier than Buffett that there have been some changes in the airline industry that are really promising. What it really comes down to is, airlines aren't trying to just pursue growth, especially the larger airlines. They recognize that they need to be businesses, and they need to make a reasonable return for their investors. So, what you've seen is, when they're doing really well, they'll grow at a 4-5% rate, among these larger airlines. As soon as their profits start to take a hit, they pull back on capacity. You're seeing right now, during the second half of 2016, airline profits are starting to pull back up a bit, and most airlines have already announced that for 2017, they're going to grow 1-2%. That slower growth means you don't need to spend as much money on new planes.

O'Reilly: For our listeners, when you say growth, do you mean expanding routes? Buying new planes? Capex? What do you mean?

Levine-Weinberg: That's a good point. By growth I mean capacity growth.

O'Reilly: So, seats. (laughs) 

Levine-Weinberg: Seats, and also distance. Sending one seat from New York to Beijing, obviously a lot more capacity than sending one seat from New York to Miami.

O'Reilly: This is an important airline industry term, like with restaurants, same-store sales growth?

Levine-Weinberg: Yeah. So, in terms of this capacity growth, the technical term is available seat miles.

O'Reilly: Insert eye roll.

Levine-Weinberg: Yeah. How many miles you send each seat, and add that up across the cross all the seats in your fleet. So, you have about a 2% growth rate or less for the three biggest airlines -- American, Delta, and United. And those are stocks that Tepper, I believe, has invested in in the past, made a lot of money there, and that's where Buffett's lieutenants made their first investments during the third quarter. With that slower growth, you have a better ability to keep fares higher, that you can earn double-digit margins or close to it, which is something that the airline industry never really did, looking back into previous cycles.

O'Reilly: With everything you've been saying, they're finally realizing they need to make money. Is the airline industry, after 80-90 years, finally maturing? What does this mean?

Levine-Weinberg: Yeah, I think it is maturing. Certainly, a lot of the problems that you saw back in the 90s and 2000s was, the U.S. airline industry was regulated up until the late seventies. So, after 1978, you had all of these airlines whose fares had previously been set by the government, essentially. Their costs were really high, they didn't have to compete on cost, so they didn't. So it's taken this long for the whole industry to shake itself out.

O'Reilly: That's a big deal, yeah.

Levine-Weinberg: And the thing is, you've had Southwest Airlines competing for a long time, but even as recently as 2000, they had something like $5 billion of revenue, which was less than 5% of the industry. Even with a company like Southwest Airlines -- a vigorous competitor, very low costs -- they didn't have the ability to completely overturn industry pricing at that point in time. Now, you have enough of these smaller airlines in addition to Southwest. You have the ultra low-cost carriers like Spirit Airlines (SAVE 1.49%) and Frontier Airlines, you have people in the middle like JetBlue (JBLU 0.70%) or Virgin America. With all of these companies, they forced the legacy carriers to get their costs to the point where they're not at parity, but they have a reasonable cost structure where they can make money year-in and year-out.

O'Reilly: Got it. Really quick, do any of the smaller carriers charge money for oxygen?

Levine-Weinberg: (laughs) Not yet.

O'Reilly: Not yet? OK, we'll find out. So, talk to me about valuations. I'm a return on capital equity guy. Talk to me about that stuff.

Levine-Weinberg: In the past few years, you've seen a lot of focus in the airline industry on return on invested capital as a key metric that airlines should be thinking about. All the airlines have different targets, different definitions of return on invested capital, but they're basically attempting to keep that at about 15%, which is a really strong number, and something you'd never seen before in the airline industry. And so far so good. They've basically managed to do that, across most of the major airlines, for several years running.

O'Reilly: Yeah, I've always been amazed. I'll occasionally check in on Southwest because I'm a regular customer. Southwest Airlines, if you're listening, I love you. What is it? It's good to be loved? Something. Anyway. But, I'm always like, wow, they actually make money. And it's just because I have that bias from reading about Buffett for 15 years, where I wonder, what is this? Free cash flow? What's going on? So, where are these guys trading? It might be that the industry is improving, it's just profile. What's going on?

Levine-Weinberg: One of the important things for investors to realize is that airline stocks are still relatively cheap compared to the rest of the market. But they're not trading at such a big discount that you can't explain it by the higher risk of the airline industry. If you look back to 2010 and 2011, a lot of airline stocks were literally trading it 4X earnings.

O'Reilly: Which is when Tepper got in.

Levine-Weinberg: And that's when Tepper got in, and that's why he made so much money. Not only did you have some multiple expansion since then --

O'Reilly: But profits went up.

Levine-Weinberg: -- but the earnings went up by a lot. Some of that was related to oil prices falling in 2014 and 2015, but it wasn't all just oil. Even before the oil prices fell in 2014, industry profits were on the rise. Right now, if you look at American Airlines and United Continental, two of the stocks that Berkshire Hathaway bought, they're trading at 10-11X forward earnings. It's less than the market, but not a lot less. Delta is a little bit under that. Southwest is a little bit above that. But that's after huge rallies in the past few months. So, we don't really know exactly when in the past five months Berkshire Hathaway bought these stocks. If you just look back to the beginning of July, since then, some of these stocks have rallied by more than 50%. So, just because Berkshire was interested four or five months ago, it doesn't mean that they would go and do the same thing today.

O'Reilly: That's a good point.

Levine-Weinberg: That's why you as an investor shouldn't necessarily run out and say, "Warren Buffett bought a bunch of airline stocks, I should too!"

O'Reilly: Right. Really quick, Buffett likes monopolies. Not literal monopolies, but consumer monopolies. And this isn't a monopolistic situation, but it feels a little bit like, possibly, an oligopolistic, just like, there's three or four big players that are really crushing it and actually making money finally. Is that part of his thinking? "They deregulated in '78, it's been an absolute massacre in terms of competition for 30 years. Is it now finally time for ... " I'm not comparing American Airlines and Southwest and US Airways to Coke and Pepsi, but, is it a little bit like that?

Levine-Weinberg: I think that's part of the story. I think that's probably why more investors are getting interested, because they see there's now four companies that can, together, control more than 80% of the domestic market, and a good chunk of the international market, as well, out of the U.S. So, they each have a stake in making sure the industry is profitable, because they know if they go out and grow 7%, everybody else is going to do the same thing, and it's going to hurt industry health profitability by quite a bit. So, consolidation has, in that way, helped the airlines to take a more balanced approach to capacity growth, and not grow when they're not making enough money to justify it.

O'Reilly: Got it. Taking a step back, happy December. We got this news recently, it was extremely jarring, at least for me, that Buffett invested in airlines, or, his company did. What do you think of where the stocks are now? Which is your favorite carrier? Help our listeners out.

Levine-Weinberg: Right now, I would say that, I've actually, in the last two months, myself, sold my personal positions in both American Airlines and United Continental. I thought they looked like really good buys when I bought them, that was quite some time ago. With the stocks having risen so much in the last few months, I didn't really see enough upside to justify the risk of holding on to that. I also personally had a lot of money invested in the airline industry, and I wanted to diversify. That said, I actually think, if I were in Buffett's shoes, I would not have gone and invested in the four largest airlines in the industry. I think some of the smaller carriers out there actually have better prospects for investors right now. If you look at companies like Spirit Airlines and JetBlue, they are trading for very similar earnings multiples compared to these much larger companies, but they have, due to their smaller size, vastly more growth potential. If you look at Spirit Airlines, the whole ultra low-cost segment right now is about 5% of the market. In Europe, it's at least 20%. This is just a movement toward cheaper fares, more fees for add-ons, that has really succeeded in other places, and it's just getting started in the United States. That's a company that has a huge runway for growth. I think in 10-15 years, Spirit Airlines is going to be 3-5X its current size, and making a lot of money. So that's one stock that I think is really compelling right now. And, JetBlue Airways is another example. They have done really well in the U.S. --

O'Reilly: And they're only -- sorry to interrupt -- 15 or 20 years old, correct?

Levine-Weinberg: Yeah. JetBlue's first flight was in February, 2000. In the grand scheme of things, they haven't been around that long. They're actually already the fifth largest airline in the U.S. But they're way behind the top four. Some of the big initiatives they're working on right now are growing in Boston, where they have actually now become the largest airline. That's the only metro area where they really have a leadership position like that. So, they're starting to attract business traffic, which was never really their thing. They'd always primarily been a leisure carrier. They've been moving even further into the business market with their new Mint product, which came out a couple years ago. This is a new aircraft configuration that they use just on transcontinental flights, mostly out of New York and Boston right now, but they're also going to be adding some other cities. They've found that fares, on average, go up about 20% when they put these planes on their new route, because the 16 seats in the front convert into fully flat beds that are 6.5 feet long. So, you have business travelers who would never fly JetBlue for a transcontinental flight because they want more space, like you could get on some other airlines. And now that JetBlue is offering this at a lower cost, they're having huge success, and they see a lot of room for growth in that market over the next three or four years.

O'Reilly: So, JetBlue is having a lot of success with letting people fly the red-eye to sleep. (laughs) 

Levine-Weinberg: Yeah! And this is even popular during the daytime. People just want more space if they can get it at a reasonable price. It's certainly not as cheap as your typical ticket. But some of these are going for as little as $600 one-way, which, when you can sometimes pay $300-400 for a coach seat, that's a pretty good deal, to get that much space, and great meals and top-notch service.

O'Reilly: For sure. Adam, thank you for your thoughts.

Levine-Weinberg: Thank you for having me on the show.

O'Reilly: I'm sure we're going to talk about this in the future, because, again, it's shocking.

Levine-Weinberg: Yeah, it's a big development, for sure.

O'Reilly: Yeah. Well, that is it for us, folks. We'd like to give a shout-out to our awesome producer, Dan Boyd. Also, before we conclude the podcast, do you own an Amazon Echo? Now you can get the brand-new skill from The Motley Fool. You can get stock quotes, create a watch list, ask Alexa how your portfolio is doing, and it is free. For more details, including a demo of how it works, just go to www.fool.com/alexa. Lastly, once again, thanks to my guest Adam Levine-Weinberg for joining us today. As always, people on this program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear. For Adam Levine-Weinberg, I am Sean O'Reilly. Thanks for listening and Fool on!