In 1989, Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) CEO Warren Buffett decided to buy preferred stock in USAir, a predecessor to today's American Airlines (NASDAQ: AAL). The investment quickly went downhill. For 25 years thereafter, Buffett repeatedly criticized the airline industry as being a terrible place to invest.
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Thus, most investors were shocked when Berkshire Hathaway revealed that it had invested in several airlines last summer. Buffett continued his buying spree in the fall, and Berkshire Hathaway now owns roughly 7%-9% of each of the four largest U.S. airlines. These investments are collectively worth about $9 billion.
Warren Buffett regretted his investment in USAir for years. Image source: Pixabay.
Here are seven different criticisms that Warren Buffett leveled at the airline industry before his sudden change of heart last year.
Airlines have been perennial money losers
Buffett's remark that investors would have saved billions of dollars if someone had shot down the Wright Brothers' plane is perhaps his best-known criticism of the airline industry. Indeed, just in the 2001-2005 period, U.S. airlines collectively lost $40 billion.
Unfortunately, that period of deep losses wasn't an isolated incident. For decades, airlines across the world have tottered between profitability and losses. In most cases, the losses have outweighed the profits over time.
The lowest-cost carriers can disrupt rivals
The U.S. airline industry was disrupted in the early 1990s by the rapid growth of low-cost carriers. These airlines undercut the legacy carriers' fares. Legacy carriers were forced to match those prices -- otherwise, their customer bases would have melted away. However, this led to big losses across the industry, as the legacy carriers' costs were way too high.
In the past 25 years, legacy carriers have reduced their costs significantly. But unit costs are starting to creep up again. Meanwhile, a new crop of ultra-low-cost carriers -- led by Spirit Airlines (NASDAQ: SAVE) -- is growing rapidly, driving fares down even further. Time will tell whether the major airlines can avoid a repeat of their early-1990s meltdown.
Spirit Airlines is spearheading rapid growth among ultra-low-cost carriers. Image source: Spirit Airlines.
Irrational competition is an even bigger danger
Another one of Buffett's key insights about the airline industry was that one or two irrational competitors could drag down the entire industry. Price wars can rarely be contained.
This fact has reasserted itself recently. American Airlines has led the way in matching Spirit Airlines' low fares since 2015 in order to avoid losing market share. The resulting fare war has even spread beyond the markets that Spirit and its fellow ultra-low-cost carriers serve. This has damaged the legacy carriers' margins.
Periods of profitability can prove fleeting
Today's airline investors take comfort from the industry's consistent profitability since 2010. However, this isn't the first long run of airline profitability in history. (To be fair, though, profit margins are much higher than during previous periods of industry profitability.)
The airlines of the 1980s had especially high cost structures. But even today's leaner legacy carriers face a severe cost disadvantage. On average, their non-fuel unit costs are nearly double those of Spirit Airlines. This could come back to haunt them if consumers begin to accept ultra-low-cost carriers' no-frills service.
When the airline industry is bad, it's really bad
Another problem in the airline industry is that one bankruptcy can lead to another. If a major airline runs into trouble, it can use the bankruptcy process to reduce its costs and get relief from debt that it may have taken on to fund its expansion. It can then use its lower cost structure to undercut other airlines on price -- potentially forcing them to seek bankruptcy restructurings of their own to regain an even footing.
Too many variables to forecast results
The volatility of airlines' earnings is another factor that can confound investors. Even at the time that he invested in USAir, Buffett knew he couldn't forecast the company's future earnings; he was just relying on its track record and the extra security of holding preferred stock.
Airline executives have shown themselves to be no better at forecasting their earnings. To give just one example, American Airlines CEO Doug Parker stated in late 2015 that the company's profit margin would probably decline in 2016 before bouncing back in 2017. American's adjusted pre-tax margin did sink by 2.7 percentage points last year. But analysts expect the company's profit margin to fall once again in 2017.
Even airline executives find it hard to forecast future results. Image source: American Airlines.
Consolidation isn't necessarily a fix
Even after airlines' profitability started to rise a few years ago, Buffett wasn't convinced that the upturn would last. As he acerbically pointed out at Berkshire Hathaway's 2013 annual meeting, every previous airline industry upturn -- of which there have been many -- has been followed by a plunge deep into the red.
Thus, Buffett wasn't convinced that industry consolidation had fundamentally altered the airline industry's long-term outlook.
Is this time different?
Clearly, Warren Buffett has changed his opinion about airline stocks. Indeed, consolidation has helped to reduce irrational forms of competition, at least somewhat. Furthermore, there is more differentiation within the industry today, with the legacy carriers focusing on business travelers while most low-fare carriers have leisure-oriented route networks.
Nevertheless, some of his previous criticisms of the airline industry still stand. Given that Buffett was wrong about the airlines in 1989, investors shouldn't ignore the possibility that he's wrong about them now, too.
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Adam Levine-Weinberg owns shares of Spirit Airlines. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool recommends Spirit Airlines. The Motley Fool has a disclosure policy.