None of the investments were especially large by Berkshire Hathaway standards. Still, given that Buffett had been steadfastly warning investors away from the airline industry for more than a decade, this apparent change of heart was especially momentous.
However, Buffett wasn't done. During the fourth quarter, Berkshire Hathaway dramatically increased its holdings of American Airlines (NASDAQ:AAL), Delta Air Lines (NYSE:DAL), and United Continental (NASDAQ:UAL) and made a big investment in Southwest Airlines (NYSE:LUV).
Warren Buffett gets serious about airlines
While Berkshire Hathaway invested in all three of the big U.S. legacy carriers during the third quarter, the largest investment by far was in American Airlines, with a value of almost $800 million. This seemed peculiar, as American Airlines has the weakest balance sheet of the three and has produced hardly any free cash flow in recent years. These traits make it the opposite of a typical Buffett stock.
With 20/20 hindsight, it looks like the apparent preference for American Airlines over its rivals was just an artifact of the timing of Berkshire Hathaway's airline stock purchases.
During Q4, Berkshire Hathaway roughly doubled its stake in American Airlines. However, it boosted its holdings of United Continental stock sixfold and increased its Delta Air Lines stake nearly tenfold. Berkshire Hathaway also acquired about $2 billion of Southwest Airlines stock during the quarter.
After this flurry of activity, Berkshire Hathaway ended 2016 with similar-sized investments of $2.1 billion in American Airlines, Southwest Airlines, and United Continental and a nearly $3 billion investment in Delta Air Lines. Berkshire now owns nearly 10% of each of the three legacy carriers and about 7% of Southwest Airlines.
This isn't an opportunistic value play
Airline stocks as a whole have rallied tremendously since bottoming out in mid-2016. An investor who bought shares of the top four airlines at the beginning of the third quarter would be sitting on gains ranging from almost 40% (for Delta) to more than 80% (for United) today.
Early in the third quarter, most airline stocks looked extremely cheap. However, Warren Buffett and his lieutenants weren't just looking to pounce on airline stocks while they were selling at a discount. Berkshire Hathaway continued to plow money into airlines even after the stocks had started to bounce back.
These aren't the best airline stocks out there
So far, Berkshire Hathaway's big airline bet has worked out, as shares of American, Delta, Southwest, and United remain near their all-time highs. However, the recent rally in airline stocks has been driven by sentiment more than performance.
As I noted earlier, American Airlines has racked up a huge debt load over the past several years and currently produces very little free cash flow. Delta and United have generated strong cash flow in recent years but have offered discouraging guidance for 2017. Furthermore, all four top U.S. carriers face rising fuel costs and a big increase in labor costs this year.
Investors hope that the airlines will be able to offset these cost pressures with a return to strong unit revenue growth. But while unit revenue trends are improving, American, Delta, Southwest, and United still face rising competition from smaller, faster-growing airlines. The legacy carriers are also feeling pressure from rapid growth by foreign carriers.
American Airlines, Delta Air Lines, Southwest Airlines, and United Continental still dominate the U.S. airline industry on a combined basis. This strong positioning -- along with a clear commitment to capacity discipline among these four airlines -- should make these stocks decent investments going forward.
However, Alaska Air, JetBlue Airways, and Spirit Airlines are all more enticing investments right now. These carriers are growing much faster than their larger rivals but they trade at relatively similar earnings multiples.
These smaller airlines have had more ups and downs than their larger brethren in the past few years, which seems to have scared off many investors. Yet in the long run, it seems clear that they will generate faster revenue and earnings growth than American, Delta, Southwest, and United will ever manage.
Based on the size of Berkshire Hathaway's investment portfolio, airlines outside the top four may have seemed too small to invest in. But ordinary individual investors have no such constraints -- and smaller airlines offer much more long-term upside.