Warren Buffett and Charlie Munger have they call a “too hard pile.” Here’s Munger on that point:
“If something is too hard we move on to something else. What could be simpler than that?”
“We have three baskets: in, out, and too tough. We have to have a special insight, or we’ll put it in the ‘too tough’ basket.”
For example, Munger makes quite clear that he does not have methods to value every company in every industry. If he can’t determine a basic fact like the present value of the business with the degree of accuracy he desires, he just moves on to the next opportunity. As another example, Buffett and Munger also simply do not like the economics of some businesses. There is no degree of difficulty premium in investing so they are easily convinced to pass on investing in a given business. This “too hard pile” approach to investing is an example of Munger’s inversion philosophy: as a first step in making decisions, eliminate everything that you do not understand or is too hard. Munger says: “I think part of the popularity of Berkshire Hathaway is that we look like people who have found a trick. It’s not brilliance. It’s just avoiding stupidity.”
Also important is to understand that Warren Buffett and Munger think in terms of opportunity cost. Again here is Munger describing the approach in the form of an example:
“There is this company in an emerging market that was presented to Warren. His response was, ‘I don’t feel more comfortable buying that than I do of adding to Wells Fargo.’ He was using that as his opportunity cost. No one can tell me why I shouldn’t buy more Wells Fargo. Warren is scanning the world trying to get his opportunity cost as high as he can so that his individual decisions are better.”
This example can be translated into a broader principle: Berkshire searches the world for its very best opportunities sorting them in terms of attractiveness from top to bottom. As an example of the method at work, if an airline stock is presented to Buffett as a potential purchase, in order for him to say “I want to buy” he must conclude it is a better opportunity than buying anything else in the world. That is a tall standard to meet. Byron Trott has said: “If you knew the deals [Buffett] turned down over the years, it would make you cry!” The only exception would be if he feels that stock adds valuable portfolio diversification. But even the desire for diversification only goes so far.
Munger is also a devotee of concentrating his investments since he is not what Buffet calls “a know-nothing investor” who should diversify. Munger has said:
“The idea of excessive diversification is madness.”
“Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.”
“The Berkshire-style investors tend to be less diversified than other people. The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results. But why would you get on the bandwagon like that if somebody didn’t make you with a whip and a gun?”
Seth Klarman similarly believes: “The number of securities that should be owned to reduce portfolio risk is not great; as few as ten to fifteen holdings usually suffice.” Jason Zweig adds:
“A conventional rule of thumb, supported by the results of Bloomfield, Leftwich, and Long 1977, is that a portfolio of 20 stocks attains a large fraction of the total benefits of diversification. … however, that the increase in idiosyncratic risk has increased the number of stocks needed to reduce excess standard deviation to any given level.”
“Even the great investment analyst Benjamin Graham urged “adequate though not excessive diversification,” which he defined as between 10 and about 30 securities.”
We can put aside the idea that Munger or Buffett would buy airline stock for diversification purposes. So let’s turn to the merits of an investment in the airline business.
Warren Buffett has said on the airline business generally:
“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down. “
“The big problem is not aggregate costs, but costs versus competitors. If your costs are out of line, you’re going to get killed eventually.”
How do others feel about the airline business? Morningstar writes:
“The airline industry is plagued by minimal barriers to entry and nonexistent customer switching costs that are further burdened with intense industry rivalry. These factors have allowed the startup of hundreds of airlines since deregulation occurred in 1978. Garnering a sustainable cost advantage is effectively the only way to generate an economic moat. Southwest used to have a low-cost advantage, but we believe competition and surging fuel prices have proved that these advantages were temporary. Southwest created this advantage by operating a point-to-point network to less congested secondary airports with a uniform fleet. These attributes maximized flying time and employee productivity, while keeping expenses at a minimum since Southwest requires maintenance and pilot training on only one type of aircraft. Over the years, competitors like Alaska Airlines, Spirit Airlines, and JetBlue have entered the market and mimicked this strategy.”
That doesn’t sound too good. Why are people attracted to the business? There can be lots of revenue. It provides great social value. I mean, what a marvelous thing to be able to fly to another city in the air for goodness sakes. But sometimes great consumer value is created by a business or industry and yet there is no long term producer profit. Airlines are a classic case where all the value has gone to the consumer and airline suppliers. As Munger likes to say, sometimes a new technology means that the business keeps nothing or less than nothing. That is why a moat is essential. And airlines, given the lack of profitability over the long term, have lacked a moat.
Adding to the problems identified by Morningstar is the fact that airplanes are mobile and can be moved to routes that might have some profit in them. Worse, some people think owning an airlines is glamorous or strategic so the business tends to attract too much interest. “This industry attracts more capital than it deserves,” complains Stelios Haji-Ioannou, founder of EasyJet.
More reasons the airline industry has been unprofitable in the long term, any one of which might cause you to avoid the industry, include:
A “capacity lead” model fostering commoditization. Airlines are managing demand to capacity, not capacity to demand.
Labour has leverage. Wholesale transfer pricing problems abound in the airline industry. Strikes!
Input costs are volatile and require a high level of cash reserve that is difficult to maintain.
The revenue cycle and cost cycle are out of sync. Fuel volatility is very difficult to manage.
Nobody really wants the lack of profitability to be fixed since the value chain, such as customers and governments benefit from cheap service.
Pricenomics wrote in November 2015: The airline industry has never enjoyed a stretch of profitability that lasted longer than 6 years. Overall, the industry has lost $35 billion since deregulation.
Munger piles on about how hard the airline business is:
“Airline pilot unions are really tough. It’s interesting to see people paid as well as airline pilots to have such a tough union. No airline can afford a shutdown very long. If you’re in a business that cannot take a long strike, then you’re playing a game of chicken with labor. Ironically, if you’re weak, you’re in a stronger negotiating position.
“Here’s a model that we’ve had trouble with. Maybe you’ll be able to figure it out better. Many markets get down to two or three big competitors—or five or six. And in some of those markets, nobody makes any money to speak of. But in others, everybody does very well. Over the years, we’ve tried to figure out why the competition in some markets gets sort of rational from the investor’s point of view so that the shareholders do well, and in other markets, there’s destructive competition that destroys shareholder wealth. If it’s a pure commodity like airline seats, you can understand why no one makes any money. As we sit here, just think of what airlines have given to the world—safe travel, greater experience, time with your loved ones, you name it. Yet, the net amount of money that’s been made by the shareholders of airlines since Kitty Hawk, is now a negative figure—a substantial negative figure. Competition was so intense that, once it was unleashed by deregulation, it ravaged shareholder wealth in the airline business. Yet, in other fields—like cereals, for example—almost all the big boys make out. If you’re some kind of a medium grade cereal maker, you might make 15% on your capital. And if you’re really good, you might make 40%. But why are cereals so profitable—despite the fact that it looks to me like they’re competing like crazy with promotions, coupons and everything else? I don’t fully understand it. Obviously, there’s a brand identity factor in cereals that doesn’t exist in airlines. That must be the main factor that accounts for it.
And maybe the cereal makers by and large have learned to be less crazy about fighting for market share—because if you get even one person who’s hell-bent on gaining market share…. For example, if I were Kellogg and I decided that I had to have 60% of the market, I think I could take most of the profit out of cereals. I’d ruin Kellogg in the process. But I think I could do it. In some businesses, the participants behave like a demented Kellogg. In other businesses, they don’t. Unfortunately, I do not have a perfect model for predicting how that’s going to happen. For example, if you look around at bottler markets, you’ll find many markets where bottlers of Pepsi and Coke both make a lot of money and many others where they destroy most of the profitability of the two franchises. That must get down to the peculiarities of individual adjustment to market capitalism. I think you’d have to know the people involved to fully understand what was happening.”
Buffett again:
I bought into an airline [US Air] with high seat-mile costs of 12 cents. It was protected, but that was before Southwest showed up with 8-cent costs.
I made a mistake when I bought US Air Preferred some years ago. I had a lot of money around. I make mistakes when I get cash. Charlie tells me to go to a bar instead. Don’t hang around the office. But I hang around the office and I have money in my pocket, I do something dumb. It happens every time. So I bought this thing. Nobody made me buy it. I now have an 800 number I call every time I think about buying a stock in an airline. I say, “I am Warren and I am an air-aholic.” They try to talk me down, “Keep talking don’t do anything rash.” Finally I got over it. But I bought it. And it looked like we would lose all our money in it. And we came very close to losing all our money in it. You can say we deserved to lose our money it.
[Question from Bill Miller: The airline industry is plagued with terrible economics. With the pending merger with U.S. Air and American (AMR)… the industry has been consistently profitable with double-digit returns. Do you think the industry’s improved economics are likely to improve?]
Warren Buffett: The answer to the second question is no. The question about the industry is interesting because it’s true it has consolidated. In some industries there are only two competitors and they still beat each other’s brains out. Freddie Mac and Sallie Mae. Two enormous companies in battle to beat the other guy out drove prices down to improper levels and did stupid things. Certain industries once down to certain levels do extremely well and others even when there’s two of them still don’t do that well. Coke and Pepsi in the U.S. are the only two colas people can name and 50 percent of drinks sold are colas, but if you go into the market on a weekend they’re pricing the product at low prices and competing vigorously. It’s industry-specific. The airline industry has situation where have very, very, very low incremental cost per seat with enormous fixed costs. The temptation to sell that last seat at a very low price is very high and sometimes it’s very hard to distinguish between that seat and the last seat. It’s labor-intensive and capital intensive and largely commody type business. As Bill Miller points out, it’s been a death trap for business since Orville took off. If it ever gets down to one airline it will be a wonderful business and the question will be if having gotten down to relatively few through bankruptcy will question be whether it is a good business yet. I don’t know the answer but I’m skeptical.
Charlie: The last time we were presented with the opportunity of the railroad we did the same thing Bill Miller would suggest. And what did we do? We missed it. We stumbled in late to the party. We proved to be slow learners. It’s conceivable that Miller is right in what he suggests. It goes into my too hard pile.
Warren: Mine too.
The Economist magazine hopefully notes that the airlines have become more sane about buying new airplanes.
These people seem to agree about how hard the airline business is as these quotes demonstrate:
1. “I really don’t know one plane from the other. To me they are just marginal costs with wings.” Alfred Kahn, 1977.
2. “Deregulation is an abysmal failure and we have no more furniture left to burn.” Bruce Lakefield, CEO US Airways, while between bankruptcies and before being taken over by America West, October 2004.
3. “I’ve said many times that I’d be thrilled to sell the airline to the employees and our guys said no, we’ll take all the money, anyway.” Robert L. Crandall, 1997. [This statement is all about wholesale transfer pricing.]
4. “I’ve got no more insight into where the [oil] price is going to go than any other person. If I knew that, I wouldn’t be an airline executive, that’s for sure.” Jeff Smisek, United Airlines, Fortune Magazine.
5. “If the Wright brothers were alive today, Wilbur would have to fire Orville to reduce costs.” Herb Kelleher, Southwest Airlines.
6. “You cannot compete in time with airlines on transcontinental runs, but [trains] can outstrip them in comfort, safety, dependability of service, and also show the passenger the countryside. This, we believe, is a permanent market.” Edward G. Budd Jr, speech before the American Association of Passenger Traffic Officers, Chicago, 24 April 1957.
7. “This is a nasty, rotten business.” Robert L. Crandall, American Airlines.
8. “I don’t care what you cover the seats with as long as you cover them with assholes.” Eddie Rickenbacker, Eastern Airlines.
9. “You absolutely, positively have to innovate-if only to survive.” Fred Smith, FedEx
10. “People who invest in aviation are the biggest suckers in the world.” David G. Neeleman, JetBlue Airways
11. “Business opportunities are like buses; there’s always another one coming.” Richard Branson, Virgin.
12. “If you want to be a millionaire, start with a billion dollars and launch a new airline.” Richard Branson.
13. “These days no one can make money on the goddamn airline business. The economics represent sheer hell.” C. R. Smith, American Airlines.
14. “Bums on seats.” Captain Eddie Rickenbacker of Eastern Airlines.
15. “Once you get hooked on the airline business, it’s worse than dope.” Ed Acker, while Chairman of Air Florida.
16. “A recession is when you have to tighten your belt; depression is when you have no belt to tighten. When you’ve lost your trousers – you’re in the airline business.” Sir Adam Thomson.
17. “Running an airline is like having a baby: fun to conceive, but hell to deliver.” C. E. Woolman, principal founder Delta Air Lines.
18. “They don’t realize that while you’re sitting here talking, someone is f**king you. Changing a fare, changing a flight, moving something. There’s no autopilot, and that’s why I’ve seen a lot of guys come and go.” Gordon Bethune, CEO Continental Airlines, regards his peers at other airlines, Fortune magazine 18 October 2004.
19. “The airline business is crazy. I’ve not been enamored with the industry in general. You can’t depend on anybody and anything. It’s dog-eat-dog and one thing or another from one minute to the next. What I understand about it, I don’t like what I see.” Robert Brooks, Hooters Air owner.
20. “The game we are playing here is closest to the old game of ‘Christians and lions.'” Robert L. Crandall, CEO & President of American Airlines.
Notes:
- A Dozen Things I’ve Learned about Investing from Jim Chanos.
- A Dozen Things I have Learned about Investing and Money from Groucho Marx
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