The worst sector for investors

“How to become a millionaire? Make a billion dollars and buy an airline” – Richard Branson (founder: Virgin Airlines)

I am not a fan of the sweeping generalization. Be it about gender “Women are not good at math”, profession “Engineers are left-brained and analytical”, geography “People from xyz are hard-working” or sport “South Africa are chokers”. To me, it represents lazy and (usually incorrect) simplification of a complex world, often done because it’s too much hard work to assess each experience.

Investing has its fair share of so-called truisms. “Real Estate gives great returns”, “Gold is a sure hedge against inflation”, “Small caps outperform Large caps” and so on. Many of them have little other than anecdotal evidence to support them, and yet, many investors live by them.

So, how about this one about airline stocks being one of the worst sector for investors?

Conventional wisdom: Survival of the fittest

Every business has its ecosystem of customers, competition, suppliers that operate within a regulatory environment. Its economics are derived from the intensity of competition (number of players competing for a slice of a growing or shrinking pie), relative bargaining power of suppliers (who needs who more) and options available to customers (whether they can stop buying your product). 

Individual firms can outperform others in an industry based on how efficient they are at running operations and creating brands that command customer loyalty. Over time the firms unable to operate as efficiently as their peers or create customer niches find their profits shrink and eventually exit the industry. Typically, in the long run, a handful of healthy competitors remain. These competitors in turn offer opportunities for investment which can be evaluated based on past performance and future prospects.

Airlines, however, have been a curiously different proposition. In spite of becoming an integral part of modern life and booming passenger traffic growth, airlines have tended to be poor businesses. Industry insiders keep referring to the extra regulation that airlines have to deal with, barring consolidation and cross-border acquisitions.

“We as an industry wish that we were treated like any other industry and were able to buy and sell across borders, and merge and do business like any other business,” – Tony Tyler, director general of the International Air Transport Association

Other reasons cited are:

  • High Fixed and Variable Costs: Large aircraft lease payments, large payroll for the  thousands of employees required, fuel prices and additional costs of security
  • Demand highly elastic:  Vulnerability to exogenous events like terrorism and weather events that affect operations and passenger demand
  • Low pricing power: Increasing perception of air travel as an uncomfortable experience owing to long lines of security, cramped seating, inconvenient schedules mean its hard for airlines to charge premium prices

However, the biggest reason the airline industry has been unprofitable for decades is that it doesn’t weed out the underperformers like most industries

The Airline Industry: Survival of the chronically sick

“Closing down a large unprofitable airline would involve the loss of thousands of jobs, inconvenience to hundreds of thousands of travelers, and millions in losses for the airline’s creditors. Not to mention the loss of national pride if the airline in question is a national carrier.”

And hence, unprofitable airlines continue to stagger on, given financial handouts under one pretext or another, destroying shareholder value in the process. No wonder then, analysis done by Mckinsey & Co showed that at an aggregate level, world airlines have consistently produced returns on invested capital lower than their cost of capital.

Source: Centre for Aviation (CAPA)

In simple terms, imagine if you borrowed to buy real estate and paid EMIs calculated at 11% interest (your WACC) and the rent + rise in property price (ROIC) was only 8% per year. You’re better off selling the property to avoid losing the 3% every year but you keep paying the EMIs even as you lose money every year.

The Indian investors perspective

Look closer to home and sure enough, we see a similar trend of rising revenues but dismal profitability over the last five years across the 3 major listed airlines (Jet Airways, Spicejet and the now defunct Kingfisher Airlines)
The Calm Investor, Airlines Revenue

The Calm Investor, PBDIT Growth

And how have investors in these airline stocks fared over the recent past?

The Calm Investor Airline Stocks

Imagine having invested ₹100 each in March 2005, in the three airline stocks discussed above. As of 20 March 2015, the ₹100 in Jet Airways would be worth ₹34 (loss of 68%), ₹100 in Spicejet would be worth ₹35 (loss of 65%). In case of Kingfisher Airlines, the ₹100 would give a whopping loss of 98.6% when it last traded on the NSE in Jan 2015.

Compare this to the same amount invested in the composite Nifty, ten years later would be worth ₹403 (gain of 4x)

Maybe there are other sectors that have performed worse for Indian investors over the same time frame. But I certainly wouldn’t want to go looking for them to make a case for investing in airline stocks. Hence, like the title of the article on ‘The Motley Fool’, the calm investor’s suggestion to Indian investors:

If you have to invest in airlines, DON’T!

Further Reading:

Why Airlines Are Still Bad Investments After 100 Years – Business Insider

4 reasons why airlines are always struggling – Investopedia

Why airlines make such meagre profits – The Economist

Why do airlines always lose money – Freakonomics

If you have to invest in airlines, Don’t! – The Motley Fool

6 thoughts on “The worst sector for investors

  • March 25, 2015 at 9:11 am
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    So sad for the industry! Why would someone like a Vistara even bother entering the space?

  • March 25, 2015 at 10:13 am
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    One of the most-repeated phrases in investing (as in many other human endeavours) “This time it’s different”, born of optimism. And who knows, maybe Vistara will do what Indigo has (supposedly) managed and run a profitable airline.

  • March 27, 2015 at 11:10 am
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    The quote “How to become a millionaire? Make a billion dollars and buy an airline” was originally from Richard Branson of Virgin group

  • March 27, 2015 at 11:14 am
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    Thanks for pointing it out Kris. I saw this quote attributed to WB in a fool.com article. Have corrected it. Cheers!

  • March 27, 2015 at 11:44 am
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    An excellent writeup with detailed charts..I also would like to add a quote from Charlie Munger, “The net amount of money that’s been made by the shareholders of airlines since Kitty Hawk is now a negative figure. “..I think its merely a fun of losing money by big and rich corporates..We had NEPC, Sahara, Damania, east west, etc…etc..but if one company closes, there is always another to fill the gap..it is also crazy to see market pricing of the airline stocks who have no net worth left but loads of debt..

  • March 27, 2015 at 11:50 am
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    Thanks Hemanth. Very relevant quote by CM. I dare say it’s the allure of seeing your logo on big expensive airplanes that gets people interested in running airlines.

What do you think?