The game of tennis is quite a spectacle to watch at the professional level. 130+ MPH serves, 5-set grudge matches, and winning shots that barely clip the edges of the court truly encompass the rigor of the sport. Winners at the professional level are in peak physical condition and have trained countless hours. They do not make simple mistakes, and they defeat their opponents with aces.
Tennis at the amateur level is a different story. The victor tends to be the player who makes the fewest mistakes such as double faults and unforced errors. A crazy shot may win the point, but how many games were lost in other attempts at the same shot? We tend to forget this mental accounting in the emotion of the game, but the numbers over time don’t lie.
Professional and amateur investors are both, in a sense, like amateur tennis players. The nature of the investment game is to make fewer capital allocation mistakes over time to achieve superior results. Adjustments are made over a lifetime of investing; the key is to be the proverbial tennis player watching others make unforced errors and not being the one to make them.
In my previous article What Is Quality Worth? I advocated for investing in businesses with strong operating and financial fundamentals. “Quality businesses” refer to companies and industries with better long-term economic prospects and little or no need to invest additional capital. Sometimes one learns what to do by seeing what not to do. As an example of what I consider an “unforced error” in investing, let’s look at the airline industry.
Of any industry, nothing destroys capital quite like airlines. The industry is rife with bankruptcies, reorganizations, and dismal returns on capital to investors. For an introduction to the returns you can expect, see American Airlines’ (AAL) 10-year chart.1
You may be thinking, “this chart only goes back to 2013.” You are correct. American Airlines filed for bankruptcy in 2011, so any prior equity in the company is now worthless. Even after a recapitalization and merger with US Airways, the company lost 31% in total returns over the past 8 years – an average loss of 4.67% each year. In contrast, the S&P 500 rose 157% during the same period – a total return of 11.8% per annum.2
You may say, “American Airlines is just one company. Maybe returns in the broader airline industry are more attractive.” To that, here’s a snapshot of the most recent earnings quality and profitability metrics of the major carriers.3
Aside from Southwest Airlines (LUV), every other major airline posted negative returns on their capital and negative operating margins – meaning they can’t even operate at a profit. To be fair, recent COVID restrictions impacted air travel and consequently, revenues and net income for the airlines. What isn’t recent are the ongoing challenges of this industry, including these three main risks:
Risk 1: Oil Prices
The price of oil is generally the airline industry’s largest input cost. Labor is the other big component. Airlines tend to lock in prices for the short term. If oil prices rise significantly, airlines operating at razor-thin margins suddenly find themselves expecting huge losses, and the market tends to value them accordingly. Large swings in oil prices also make it difficult for airlines to price tickets efficiently. Businesses at the whim of the commodity cycle are less likely to generate consistent long-term returns on capital.
Risk 2: Industry-Wide Financial Leverage
Financial leverage within the airline sector also contributes to ongoing operational stress. When firms lose money on an operational basis, they can either finance their shortfall and ongoing operations with current cash, debt, or equity issuance. With such a capital-intensive business line, retained cash alone will not cover costs in a loss year. This means that debt or equity must be issued to fund the gap. Debt tends to be favored as it’s less costly than equity to issue, it’s tax-advantaged, and airlines have hard assets to use as collateral so they can get relatively better lending terms. Total long-term debt levels for the largest carriers since American’s recapitalization are shown below.4
Their respective market caps were as follows.5
As evidenced by the bankruptcy history of the industry, this is not just a pandemic phenomenon. From a financing perspective, these firms are extremely sensitive to interest rate movements. Any increase in financing costs can ultimately destroy profits and shareholder capital. As firms get more indebted relative to their assets and earnings power, these concerns amplify over time.
Risk 3: Low-Margin for Error
The lower a company’s operating margins, the lower the operating margin of safety the business enjoys. Businesses with higher margins that can be maintained due to a strong brand presence, engrained user base, or any other differentiating factor have leeway to experiment with defenses against competitive threats.
Commodity products and services have no such economic freedom. Airline travel is, to a great degree, a commodity product. When presented with two flights to the same city, the main thing passengers check is the ticket price and how it compares to similar flights. They choose the cheapest option, whether it’s from United, Southwest or another carrier. There is very little customer loyalty to airlines, and they will generally not pay up for a favored airline experience. Since airlines have little pricing power, they are continually strained with less-than-enviable margins. Combined with the previously mentioned risks, this results in an ongoing chaotic business operating cycle for airlines that I would avoid as a long-term capital allocator.
When thinking about the analogy of avoiding those investing “unforced errors,” it is simpler to think of business lines that are easier to make money in with a degree of consistency. I am not saying there’s no use for airlines or their stocks. In fact, the companies provide a valuable service, and the higher volatility of their stocks can serve short term trading strategies much better than less volatile equities.
However, over the long term, the nature of the underlying business tends to win out much like the amateur tennis player’s focus on limiting unforced errors. Companies with strong operating fundamentals and management teams that operate in industries with better economics have an increased ability to compound capital at a greater rate for a longer period. Game. Set. Match.
Dean Schwefel, CFA®
Senior Investment Analyst
1. YCharts. American Airlines Total Return 5/11/12 – 5/12/2022.
2. YCharts. AAL vs. SPY Annualized Total Return 5/11/12 – 5/13/2022.
3. YCharts. Comparative Earnings Quality & Profitability Metrics for Broader Airline Industry – 5/13/2022.
4. YCharts. Total Long-Term Debt of UAL, AAL, LUB & DAL since 12/11/13.
5. YCharts. Market Caps of UAL, AAL, LUB & DAL – 5/13/2022.
Disclaimer: Investing involves risks, and investment decisions should be based on your own goals, time horizon, and tolerance for risk. The return and principal value of investments will fluctuate as market conditions change. When sold, investments may be worth more or less than their original cost. The forecasts or forward-looking statements are based on assumptions, may not materialize, and are subject to revision without notice. The market indexes discussed are unmanaged, and generally, considered representative of their respective markets. Index performance is not indicative of the past performance of a particular investment. Indexes do not incur management fees, costs, and expenses. Individuals cannot directly invest in unmanaged indexes. Geneva Partners LLC does not hold the securities mentioned in this article in current client or advisor portfolios. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.