I’m Not Done Talking About Airline Stocks

by JT McGee

In last week’s post about how everything you’ve ever thought about stock picking is wrong, I outlined a strategy that I know will outperform the benchmark.

My methodology was simple: remove airline and shipping stocks. The economics of the business model make both industries guaranteed money losers, and at best, guaranteed to generate returns on investment capital below the market averages.

That claim drew a little bit of heat. It’s a big claim – people don’t like to hear that they can beat Wall Street. It’s counter to everything you’ve ever heard. Not all that surprisingly, Ben Graham and Warren Buffett would likely nod their heads in agreement with what I said. There’s a reason why value investors have the best track record of any style. Anyway…

Now I Have Historical Proof

This is a chart of the airline industry from 1992 to 2010. (This particular index has not moved since 2010, which I confirmed with Bloomberg’s free data.)

The long story short is this: airlines in the aggregate produced total returns of -10% from 1992 to 2012. Yes, you read that right. Any dollar invested in the airlines in 1992 would be worth $.90 today. That return is not inflation-adjusted – if it were, returns would be considerably lower.

Meanwhile, Vanguard’s Total Stock Market Index fund is up 327.3% since 1993 (this is as far back as I can go.)

So, $1 in airlines = $.90. $1 in the Total Stock Market Index = $4.273 net of fees. In short, there’s no way the TSM Index ex-airlines would have underperformed the whole TSM Index since inception.

I’m still trying to locate some data on the Lloyds List-Bloomberg Top 50 Shipping Index, which tracks the value of the 50 largest ocean shipping companies over time. The free data reflects what I would expect – a 60% decline in the last 5 years. If anyone has access to a Bloomberg terminal, please help! Also, if anyone knows of an index for the whole shipping industry, I’d love to hear about it. (I would guess the smaller companies would only push returns down – click through the many “related stocks” similar to DRYS and look at their history. Wall Street had a blast unloading these worthless firms to investors at the top of a cyclical boom in shipping.)

Why These Businesses Suck

I’m not just cherry-picking evidence. Both airlines and ocean shipping companies share a few economic similarities in their business models:

  1. No differentiation – Shipping people and cargo is a commoditized service. There is very little brand loyalty, because everyone sees products from one company to be the same as the other. It’s all about who can do something at the lowest possible cost.
  2. No advantage – Shipping companies order their ships from the same shipbuilders. Shippers ship goods to the same ports over the same ocean. Airlines get their jets from the same aircraft manufacturers and service the same airports. Pilots are sourced from the same training schools and military. Everything is the same from business to business, so it is impossible to have an edge on the competition.
  3. Easy startup – Airlines were deregulated in the 1970s, making it possible for anyone to start an airline. But this isn’t the only negative. Both airlines and shipping companies purchase airplanes and ships on lease from specialized financing companies. This makes it possible for someone to start an airline or shipping company with far less cash than they would need if they were to buy their on ships and jets outright.
  4. Cost structures – One would think that a bankrupt competitor should be a boon for your business. But this is NOT how things work. Let’s say the average airline pays $50 in interest expenses in leases etc. per customer, per flight. Now, one airline with the same interest costs goes through bankruptcy and converts debt to equity, giving ownership to bankers who previously held its debt. This company no longer has the $50 in interest expense per customer that every other company has. It can afford to sell at a lower price than any of its competitors in a commoditized space. No airline can compete on price without losing money. The economics are the same for shippers – make it $50 in interest per container, or whatever you’d like. It’s the same for retail, too. For every $1 in stuff Best Buy sells, it has interest expenses of 2.7 cents. Amazon, by contrast, has $0 in interest expense. If people do not care where they buy the product because retail is a commodity, Amazon can always beat Best Buy on price, therefore winning customers. If you sell a commodity you have to be the cheapest possible provider, end of discussion.
  5. No variable costs – Most costs in sea shipping and airlines are fixed. One more person on a plane or one more container on a ship does not significantly add to expenses, as expenses are mostly fixed. Therefore, one less person on an airplane or one less container on a ship greatly reduces income. When you have high fixed costs, you are destined to lose piles of cash on the smallest of downturns, especially when margins are already razor thin.

But what about efficient markets?!

Let’s assume that efficient market hypothesis is perfect – that any given stock is ALWAYS priced intelligently based on its future income potential. This might be the most irrational claim ever, but we’ll go with it.

EMH ignores the importance of the aggregate – the combined value of all stocks in an industry. There will be single airline companies that make money. There will be single airline companies that loses at lot of money. All told, I expect airlines to put a TON of capital to work, and generate returns at or around 0% per year. If history proves to be a reliable guide, airlines will generate negative earnings over time.

If you buy a whole industry (and you do when you buy a Total Stock Market Index) you buy into the good and the bad in an industry. So, Wall Street might say that Southwest Airlines is worth $6.3 billion and it has excellent opportunities to make money in the future. Maybe that’s true for this single company. But in highly-competitive spaces (efficient markets!) the total earnings of all firms will be nearly zero. You might make money on Southwest, but you’ll give it up on the money you lose to airlines that go broke to give Southwest its profits.

Example: Let’s say one airline makes $500 million per year. Another loses $300 million, and another loses $250 million. Combined industry earnings are -$50 million per year. And we’ll say these earnings are constant in perpetuity. If you buy airline #1 and airline #1 alone, you will obviously make money. If you buy all three under the guise of safety from diversification, you PAY MORE for a share of a future stream of income worth -$50 million per year than you would pay for a single company that makes $500 million per year. That is absolutely insane, but something many investors are willing to justify on the premise of markets being 100% efficient all the time.

In short, indexing has a very serious flaw in that it buys whole industries where the whole industry is economically guaranteed to produce negative returns. Single companies can make money in these industries, the whole industry, however, cannot make money in the long-run. More importantly, the entire industry cannot (thanks to competition) enjoy very high returns on invested capital.

But don’t let me stop you from indexing. I don’t think any amount of proof that EMH is flawed will change minds. Go forth, buy everything!

{ 5 comments… read them below or add one }

TB at BlueCollarWorkman May 21, 2012 at 07:41

In my job, I wonder about the rational thinking of people sometimes. People think with random feelings a lot or they just plain don’t think rationally, and so when I read “Let’s assume that efficient market hypothesis is perfect – that any given stock is ALWAYS priced intelligently based on its future income potential”, I laughed out loud, dude! So true!

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JT May 22, 2012 at 13:06

The last price for any security is set by the latest sale, which could be just about anyone. So, yeah, the depressed, angry, upset, or irrational person decides what an entire company is worth with one trade. But markets are efficient!

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PK May 22, 2012 at 10:48

“But in highly-competitive spaces (efficient markets!) the total earnings of all firms will be nearly zero.” – I think you mean inflation + population growth + productivity increases +/- some adjustment for other companies in the world here. Assuming a nearly zero sum game with industries with heavy competition would mean things like farming would be unprofitable.

Still, airlines and shipping? Not for me.

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JT May 22, 2012 at 13:09

I think we’re more limited by quality farmland than we are the ability to put people in the sky. Even still, farmers may be killing it now, but that certainly wasn’t the case even 10 years ago. Returns on capital are abysmal.

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Value Indexer March 6, 2013 at 12:04

If a company is losing $300m/year and goes bankrupt every 6-8 years, what’s driving active investors to keep the stock price above $0.02? You can say it’s all index investors buying blindly but at some point a stock with no real demand will get removed from the index.

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