No matter how skilled, patient and farsighted you are as an investor, when you’ve been around for many decades you inevitably end up getting burned by companies or even entire industries bad enough that you foreswear ever again touching them. For Warren Buffett that industry has been commercial airlines, which even in the most benign economic environments have a long and storied history of imploding and taking with them shareholders’ investments.
So, with well-documented struggles in the past does the added shock of Brexit prove that Buffett was once again correct in avoiding airline shares?
Well, the performance of International Airlines Group (LSE: IAG), the parent of BA and Iberia, since the EU referendum would certainly suggest Buffett was on to something as the shares prices have plummeted 25% over the past six months.
Brexit hasn’t caused this stunning slump on its own, but it’s certainly partly to blame. That’s mainly due to the fact that IAG reports in euros and there’s the potential for less business travel to the UK, which would be particularly harmful to the highly profitable transatlantic routes that are BA’s bread and butter.
But, as long-term investors like Buffett, should we ignore these short-term bumps in the road? I don’t think so. The problem is that I don’t believe airlines have corrected the fundamental flaw in their business, which is that as consumer demand grows airlines add extra availability. This is great while demand is steadily rising, but once it inevitably falls it leads to excess capacity, stubbornly high costs and price wars as competitors scramble for market share.
We’re already seeing this in reports from the International Air Transport Association. Data from August, the latest month on record, shows global year-on-year demand growth slowing to 4.6% while capacity rose 5.8%. It doesn’t take a maths genius to realise why this is a problem for IAG, and one that will only become worse if tepid economic growth reverses post-Brexit. IAG shares have performed remarkably well since the Financial Crisis but I reckon the coming quarters won’t be nearly as profitable for shareholders.
Is budget best?
The market has been much kinder to the king of budget airlines, Ryanair (LSE: RYA). Despite greater reliance on struggling European markets, shares of the low fare carrier are down a mere 4% over the past six months.
What explains Ryanair shares’ relative stability compared to IAG? The primary answer is that Ryanair’s underlying business is on much sounder ground than its larger competitor.
We can see the difference in 2015 underlying operating margins of 22% for Ryanair compared to a more sedate 10% for IAG. Certainly some of this is down to IAG’s business model of buying up less-efficient airlines and streamlining them, but this acquisitive nature leads us into the next main difference. While half year results for IAG saw net debt stand at 1.7 times EBITDAR, Ryanair’s balance sheet was in rude health with €162m net cash at the end of Q1.
Although Ryanair to me is a more attractive business than IAG, it’s still facing the prospect of a turbulent few years. Fares are already starting to come down among budget carriers and Brexit-related uncertainty will only make this worse. I’ll be watching Ryanair closely in the coming years but have to side with Buffett and exercise caution on the industry as a whole.
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Ian Pierce has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.