Airline Investors Should Heed Warren Buffett's Wisdom

It's well known that investing legend Warren Buffett avoids airline stocks like the plague. He once blamed an investment in US Airways on "temporary insanity" -- even though he actually made money on the trade! Despite Buffett's aversion to airline stocks, they have been among the best performing investments of the past year. Investors who ignored his advice about airline stocks last year did very well.

However, airline investors should heed a more general piece of wisdom from Warren Buffett: "Be fearful when others are greedy, and be greedy when others are fearful." At this time last year, airline stocks were still hated, and this made them a good contrarian investment.

United Continental is one of many airlines that are priced for significant long-term margin growth.

By contrast, the big airlines such as Delta Air Lines , United Continental , American Airlines , and Southwest Airlines have very bullish expectations baked into their stock prices today. As a result, it's a good time for airline investors to be fearful, and consider taking profits.

Buyer beware?
Buffett believes airlines are terrible investments because they tend to require lots of upfront capital investment to grow quickly but earn razor-thin profit margins. However, some airlines are more capital-intensive than others.

Among the "big four," United and American are plowing every bit of cash they generate into their aircraft fleets. By contrast, Delta and Southwest are taking a more measured approach to capital investment.

Delta Air Lines has managed to avoid many of the pitfalls of the airline industry.

More importantly, some airlines have been able to boost their profit margins in recent years. Delta Air Lines proudly announced last month that it had earned a record-setting profit in 2013. After a very strong December, the company appears likely to post a pre-tax margin of nearly 7% for the full year.

Thus, Buffett's blanket criticism of investing in airlines seems too harsh. A bigger concern is that airline valuation multiples have soared this year. United and Delta have seen their forward earnings multiples double since early 2013, while Southwest has also seen substantial multiple expansion:

UAL PE Ratio (Forward 1y) Chart

Airline Forward Earnings Multiples; data by YCharts.

Southwest's valuation is now roughly in line with the broader market. While United and Delta still seem fairly cheap based on forward earnings multiples, their balance sheets are not as good as a typical large-cap company. (The same will be the case for the new American Airlines.) Moreover, the airline industry is extremely competitive and has fairly minimal barriers to entry and expansion, justifying lower multiples for airline stocks in general.

But everything's different!
A common refrain among airline bulls is that "everything's different this time." In other words, while every other upturn in the industry has been followed (eventually) by a downturn, bulls argue that airlines now have a clear path to substantial and sustainable earnings. Typically, this is attributed to the recent wave of consolidation in the industry, which has reduced competition, or to a new profit-oriented mind-set among airline executives.

In reality, this is a dangerous over-simplification. It does appear that airlines are becoming more disciplined about keeping capacity growth in line with demand. This should allow airlines to earn back their cost of capital over the course of the business cycle. The endless cycle of airline bankruptcies is over.

However, some airlines are already earning more than their cost of capital, and sector valuations now imply that airline earnings will rise even further. In other words, many airlines now trade as if they can sustainably earn well beyond their cost of capital.

This argument is harder to swallow. While the top four carriers now control more than 80% of the domestic market, if they attempt to exploit this position to earn monopoly-like profits, smaller and hungrier airlines will expand to grab a share of that profit. The major airlines have no moat to stop competitors from growing and stealing market share if there's lots of money to be made.

Indeed, at the peak of the last airline bull market in 1999, Southwest Airlines' revenue was just $4.7 billion, less than JetBlue Airways' 2013 revenue. Since then, Southwest has grown significantly to become one of the "big four" airlines.

JetBlue is a relatively small player today, but that won't be true in a decade. (Photo: JetBlue.)

Today, Spirit Airlines and JetBlue look like the two carriers most likely to grow aggressively and challenge the "big four." Both carriers already have large numbers of planes on order through the end of the decade. If industry profit margins continue to rise, they would be likely to ramp up expansion plans even further.

Time to reassess
The growth of smaller carriers won't happen all at once. In fact, it's quite likely that airline profit margins will rise again in 2014. However, investors shouldn't be tricked into thinking this is the "new normal." If 2014 turns out to be as good as the early signs indicate, capacity growth is likely to ramp up in 2015 to the point that industry margins stagnate or begin contracting.

To put it simply, airline investors have started to become greedy. Many have quickly written off decades of turbulence in the airline industry, even though every other airline bull market in history has eventually ended with a big downturn. Wise investors should heed Warren Buffett's wisdom and be fearful when looking at the airlines in 2014. Don't sell in a panic, but be wary of viewing the airline industry through rose-colored glasses: This is still one of the riskiest businesses out there.

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Adam Levine-Weinberg is short shares of United Continental Holdings. The Motley Fool recommends and owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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