Just a few months ago, Berkshire Hathaway (BRK.A -0.46%) (BRK.B -0.47%) was one of the largest shareholders of all four top U.S. airlines: American Airlines (AAL -1.11%), Delta Air Lines (DAL 1.31%), Southwest Airlines (LUV -6.67%), and United Airlines (UAL -0.33%). Warren Buffett's conglomerate owned stakes of roughly 10% in all four of these stocks. As of the end of 2019, Delta, Southwest, and United all ranked among Berkshire Hathaway's top 15 equity investments.
However, the COVID-19 pandemic has caused air traffic to come screeching to a halt. As a result, airlines have been reporting losses for the first quarter and expect a tidal wave of red ink starting in the second quarter. Unsurprisingly, these stocks have plunged since mid-February.
Comparative performance. Data by YCharts.
This market crash gave Buffett an opportunity to increase Berkshire Hathaway's airline holdings at lower prices than what it had a paid a few years ago. But instead, Buffett chose to sell all of Berkshire's airline holdings at a loss, as he revealed on Saturday at the company's annual meeting.
Buffett's unexpected airline romance
Berkshire Hathaway first started investing in airlines in the third quarter of 2016. At the time, one of the conglomerate's two portfolio managers -- either Todd Combs or Ted Weschler -- bought shares of American Airlines, Delta Air Lines, and United Airlines. Soon thereafter, the Oracle of Omaha himself got involved. In the fourth quarter, he added Southwest Airlines shares to Berkshire Hathaway's portfolio. And over the next three years, he significantly increased Berkshire's holdings of all four airlines.
Buffett's decision to get involved with airline investing a few years ago was always a bit of a head-scratcher. For years, he had been warning followers about the danger of investing in this realm. Over that span, he frequently described airlines as capital-intensive commodity businesses that were doomed to destroy investors' capital.
Presumably, Buffett changed his mind sometime around 2016. He was probably impressed with a solid streak of significant free cash flow generation at Delta, Southwest, and United. This seemed to indicate that the airline industry had matured; rather than fighting for market share at the expense of profits, airlines were focusing on generating strong returns for investors. That said, Berkshire Hathaway also opened a big stake in American Airlines, which was barely generating any free cash flow in the midst of an industry boom, due to extremely high capex.
Airlines like Delta have generated lots of free cash flow over the past decade. Image source: Delta Air Lines.
Airlines no longer fit Buffett's investment style
Investors first got a hint that Buffett was selling airline holdings in early April, when regulatory filings showed that Berkshire Hathaway had sold some of its shares in Delta and Southwest. This brought the conglomerate's stakes in those two carriers below 10%, at which point it was no longer obliged to file prompt notices of any further sales (or purchases) of those stocks.
Some investors speculated that Berkshire Hathaway may have wanted to reduce its stakes to less than 10% due to language in the CARES Act that could have prevented major holders of airline shares from buying additional shares in the near future. To put it bluntly, they were hoping that the stock sales were just the first move in a bigger plan to try to buy either Delta or Southwest outright.
This idea wasn't totally implausible. Buying an airline like Delta Air Lines would have allowed Berkshire Hathaway to put a lot of cash to work at once. Moreover, with Berkshire's backing, Delta would have had the ability to make big investments that rivals couldn't afford, putting it in position to exit the crisis in a dominant position.
However, as I noted in late March, Buffett's investment philosophy prioritizes owning high-quality companies. Clearly, no airline can be considered a high-quality business right now. Sure enough, in his remarks at the annual meeting, Buffett said that he had made a mistake with respect to the airlines and chose to make a clean break by selling all of Berkshire Hathaway's airline holdings.
I won't be following Buffett's lead
While I wasn't surprised by Buffett's decision to exit Berkshire's airline investments, I don't plan to follow suit. At 34 years of age, I have plenty of time to be patient, and I expect higher-quality airlines like Southwest and Delta to make a full recovery in the years ahead.
Buffett appears to be worried that airline traffic will remain below 2019 levels for many years to come. I am significantly more optimistic on this score. To be sure, even if a vaccine becomes available sometime next year, air traffic is likely to remain well below 2019 levels in 2021, and possibly even 2022. But by 2023 or 2024 at the latest, I expect the global economy to return to health, driving a rebound for the airline industry as individuals and businesses make up for all the travel they are missing out on now.
Furthermore, I think Buffett is underestimating airlines' ability to make money during a period of lower demand. While it's impossible for airlines to avoid massive losses when demand is down more than 90% from normal levels, they have plenty of tools to adapt to a world where travel demand is 10% or 20% lower than previous levels (which could be the case in the second half of 2021 or 2022). Older planes that are more expensive to operate can be retired. Labor costs can be reduced through attrition, buyouts, and reduced overtime work. Less-profitable flights can be cut while leaving the most lucrative routes intact.
Thus, I think investors have overreacted by knocking more than $20 billion off of Delta's market cap and about $15 billion off of Southwest's market cap since February. I boosted my stakes in both airlines last month. If airline shares fall this month due to the news about Berkshire Hathaway's sales, I will probably continue buying.
