In the last few newsletters we've lookedat the USAir case study to try to discern general lessons for less experienced investors than Warren Buffett. So what can we take away?
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Having presided over USAir loses cumulating to $2.4bn in 5 years Seth Schofield led the company back to profits in 1995. But, unfortunately, he had still not gained enough concessions from the intransigent unions to give any surety of future profits. The Washington Post commented that ironically the first sight of a profit became a problem because when the airline began to make money “the union membership saw less need to grant concessions.” Schofield was constantly up against this Catch 22.
Through much of 1995 Buffett tried to sell Berkshire’s preferred stock at 50% of face value but couldn’t find takers. In September, with the common stock down at $8, a frustrated Schofield resigned as Chairman and CEO. A few months later there was yet another blow: British Airways was forming an alliance with American Airlines, tying up the lucrative US-London market and excluding USAir. AA and BA were to share passengers; coordinate fares, schedules and ticketing; and pool profits on some routes. The people at USAir felt betrayed and sued to break its deal with BA. The arrangement had, after all, bought BA a great deal of power in the US boardroom, but little for USAir in the way of access to European markets as BA blocked its efforts to go there. Acrimonious divorce proceedings slogged their way through 1996. The leadership of USAir was taken by Stephen M. Wolf in January 1996. A former Chairman of United Airlines, Wolf was determined that USAir would no longer muddle along as a medium-sized airline with high costs and negative margins. It would either shrink back to being a regional carrier or, his preferred option, modernise and grow to become major global competitor with the most up to date fleet, manageable costs and profitable routes. These are the options he presented to the unions. To show what he was aiming at with the growth option he made arrangements to buy 400 new jetliners from Airbus worth $15bn over the following decade, replacing the hodgepodge fleet of older planes from several manufacturers (the old fleet was expensive because each type required separate maintenance procedures, spare parts inventories and crew training). So that was this shiny new future pilots, cabin crew and ground staff were invited to gaze upon. As they excitedly pondered that sunny picture the wily Wolf had a big but: the planes were on order but could be cancelled at the drop of a hat. If the unions refused to be reasonable then Wolf would take the firm in the opposite direction resulting in closed routes and massive redundancies. The choice was theirs to make: be reasonable on salaries, work rules, etc., (pilots were on $120,000 per year on average for example) or risk seeing most of your colleagues disappear. Oh, and there was a third option: Wolf let it be known that he was in discussions with both United and American to sell the company to one of them. Do you, union leader, want to be run by their executives, who might have a view on cutting overlapping routes following amalgamation? Wolf was looking for annual $500m concessions to lower costs per available seat mile from the highest in the industry at 12.69 cents to nearer Southwest’s 7.5 cents. The blink Negotiations dragged on, so in early Spring 1997 Wolf warned that he would begin laying off pilots and other employees by June 30th unless agreement had been reached. If things were still not headed in the right direc………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 When USAir's Ed Colodny retired in Summer 1992 - three year after Buffett had bought preferred shares for Berkshire Hathaway - his chosen successor, Seth Schofield, became Chairman as well as CEO. Schofield had come through the ranks, starting at 18 as a ramp agent: loading bags, selling tickets and boarding aircraft. He was a popular “blue-collar guy” with a reputation for caring about his employees and had a strong rapport with union bosses.
Buffett really liked him and his actions, “Seth Schofield is making major adjustments in the airline's operations in order to improve its chances of being one of the few industry survivors. There is no tougher job in corporate America than running an airline: Airline managers need brains, guts, and experience - and Seth possesses all three of these attributes.” (Buffett's 1992 letter to BH shareholders) But Summer 1992 was a bad time to take on the leadership of a firm which only weeks before had reported a massive $305m loss. It was still reeling from two fatal crashes which sapped the spirit of employees and damaged the company’s image with passengers. Even worse was the perennial problem of carrying much higher wage costs than competitors, and the unions’ imposition of crippling work rules. Schofield faced down unions through the Fall 1991 strike, but this was not enough to save USAir from continuing to report losses exacerbated by yet more strikes and by yet more competition. The biggest blow was the entry of low-cost Southwest to Baltimore routes in 1993. They hammered air fares. USAir, not to be outdone in its home market, pitched its fares below Southwest, which prompted another round of fare reductions. The ratcheting-down didn’t stop until it was only $19 to fly Baltimore to Cleveland. Of course, the result was a lot of red-ink. To make matters worse Continental started offering low-fares out of North Carolina. And American, Delta and United kept adding capacity and discounting fares too. A helping hand from the Brits Fully aware of growing losses and balance sheet debt ballooning to $2.2bn the board found a way of gaining some cash and customers. It agreed in 1993 to sell a 44% ownership stake to British Airways in return for $750m (BA’s votes were limited to 21% due to Federal rules on foreign investment). This Alliance bought together the largely domestically focused USAir, carrying 55m passengers annually, with the internationally focused BA serving 24m flyers. Each airline could feed customers into the other’s network, expanding the range of destinations to 77 countries, and they could integrate marketing and some other functions. Schofield said the deal will “ensure our survival”. Buffett agreed it would help it dodge bankruptcy and hoped the path was now “eventual prosperity”. BA took four seats on USAir’s board and the…To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 When judging the value of a share, a bond or a business Buffett encourages us to go back to basics as set out in John Burr Williams’ book The Theory of Investment Value (1938) and to see value being determined by estimated future cash inflows and outflows, with each forecast net cash flow for a period being discounted at an appropriate interest rate.
The logic of using discounted flows of cash applies to shares, where there is greater uncertainty over what cash will be generated in say 5 years or 10 years, as much as it does to bonds, with their defined payment amounts and dates. Of course, the analyst has a tougher job estimating the cash attributable to shareholders than for bondholders. Equity flows are subject to significant variability due to a whole host of qualitative factors, from the morale of the workforce and the behaviour of competitors to customers changing preferences and the competence of managers. “The quality of management affects the bond coupon only rarely - chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity ‘coupons.’” (Warren Buffett’s 1992 Letter to Berkshire Hathaway shareholders) Despite the difficulties with equity valuation it is better to think through the issues within the framework of discounted cash flow, with its forward focus and its discounting discipline, rather than lazily adopt measures such as multiplying last year’s profits or, worse, using EBITDA or, more frighteningly, “adjusted” EBITDA. Managers and discounted cash flow In addition to investors valuing shares using the discounted cash flow method, corporate managers should also apply it when considering growth in the company’s asset base. This will bring them to a deeper understanding that “Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.” (1992 Letter) Airline growth was certainly hurting investors. Acutely so for the common stockholders, but it was also bad for preferred stockholders because operating losses were so poor that there was doubt that USAir would be able to maintain the preferred dividend, hence Buffett’s estimated 35% drop in the value of Berkshire’s holding to $232.7m. Applying discounted cash flow logic to building a portfolio The investment to be bought is the one that is cheapest relative to its value determined by discounted-flows-of-cash calculation, “irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.” (1992 Letter) I’ve found to my cost the impossibility of disabusing many managers from the notion that their shareholders want the prioritisation of turnover and earnings per share growth regardless of value creation. These managers often operate in industries where any newly allocated capital ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 In 1989 Warren Buffett's Berkshire Hathaway bought $358m of preferred stock in USAir. It took only months for the airline’s managers indicate that losses were going to be made in both 1989 and 1990. That news sent the common stock to around $30, far below the $60 required to make it worthwhile for Berkshire to convert the preferred stock to common.
Writing his 1990 letter, wrapping his embarrassment in irony, Buffett told his shareholders that in making the USAir purchase he had “displayed exquisite timing: I plunged into the business at almost the exact moment that it ran into severe problems”. He added that no one had pushed him; in tennis parlance “I committed an ‘unforced error’”. Almost everything that could go wrong went wrong:
The resulting operational and service hiccups caused USAir to fall so far from grace that is was ranked as the worst in the industry for on-time performance. Ed Colodny, acknowledging the problems, told the Washington Post in September 1990, “When the economy is growing, growth covers up a lot of sins” (Martha M. Hamilton (1990) USAir Group Flies into Turbulence, September 3).
When some in the industry are stupid enough to offer prices below operational costs it’s difficult for more rational players to stand apart and try to sell tickets at higher prices, “The trouble this pricing has produced for all carriers illustrates an important truth: In a business selling a commodity-type product, it's impossible to be a lot smarter than your dumbest competitor.” (1990 letter) Bankruptcy law made matters worse because airlines were kept operating under bankruptcy court protection, including reducing or eliminating their previous debt burden. Thus, surplus capacity was not eliminated, and, relieved of the cost of debt, the zombie companies tended to price fares aggressively.
The poor outlook was worsened by a more than doubling of oil prices following Iraq’s invasion of Kuwait August 2, 1990. The combination of higher fuel costs and slackened consumer demand was a dreadful mix. Recently added airline capacity was met with little or no growth in demand resulting in carriers facing the dilemma of flying empty or battling to fill seats with discounted fares. USAir cut its workforce by 7% (3,585 people) and implemented other cost savings but still it racked up loses both in 1989 ($63m) and in 1990 ($454m). Of course, common stock nosedived, all the way to $14. Despite the troubled first year Buffett, writing in February 1991, was convinced that “our investment should work out all right” but he acknowledged it was less secure than at the time he made it. Things can only get worse 1990 was a bad year, but 1991 was terrible. In fact, it w………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 Carl Icahn, an activist investor, had gained control of TWA in 1985 and immediately started calling Colodny to push for joining TWA and USAir, “He used to get on the phone and we’d go on for 30 or 40 minutes at a time. He would say we pay employees too much…and if we merged with TWA he could force us to take the same wage cuts TWA had put on their employees. I told him that, in that case, he would have a lot of very unhappy employees providing very bad service.” (Ed Colodny quoted in Reed, T and Reed, D. (2014) Creating American Airways: The Converging Histories of American Airlines and US Airways. McFarland & Co. p. 11)
Icahn tried to stop the Piedmont merger, finally sending a letter to Colodny on the day the USAir and Piedmont boards were due to meet (March 4, 1987) to approve the start of the deal process. In it he offered to buy USAir for $1.64bn ($52 cash for each of USAir’s 31.56m common shares). TWA was already USAir’s largest shareholder and Icahn indicated that if his “friendly” deal could not be agreed he was prepared to go hostile. Very quickly Colodny obtained a court order preventing TWA acquiring more USAir stock. Also, the deal with Piedmont was sealed. TWA withdrew its offer, and before the end of the month had sold its USAir holding for $180m, having previously paid $178m. One raider had been stopped but more were waiting in the wings. Michael Steinhardt’s $1.3bn fund, with a reputation for aggressive trading, bought a 5.89% stake in July 1989 and seemed poised to mount a hostile takeover bid. Steinhardt’s public statements such as “we might consider seeking control of the rapidly growing airline” didn’t help the mood at USAir HQ. The directors felt the need for defences. One “poison pill” they approved was to grant the right to existing shareholders to buy USAir shares at below market price if a potential raider acquired 20% or more of the group (such poison pills are not allowed in the UK). They also authorised a repurchase of up to 5m s………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 If you were pondering whether we are now out of the woods and it’s a good time to go back into the stock market in a big way you might want to first consider the recent words of some key people.
Paul Romer, Nobel Prize winner in Economics Paul Romer suggests that the best strategy out of the crisis is to conduct 150m test per week in the USA. He says that by randomly dividing the US population into 14 groups and testing each group every two weeks they’ll be able to monitor to see who has the disease now. The cost is $100bn per year, which he considers cheap compared with the alternatives (Herd immunity or Lockdown). Thinking of lockdown: “maybe in 18 months in 24 months we get a vaccine, maybe we don’t. It’s costing us 20% of GDP loss every single month. And we might have to do this for years on end. That’s a really horrific alternative – a catastrophe that’s worse than the great depression. That doesn’t just make us poorer; that may destroy our democracy and our entire social life. Think about the political ands social upheaval that we had during the Great Depression. The alternatives to 150m tests per week [herd immunity with 1m deaths or lockdown] are just horrific.” (Heathcare Triage website 2 weeks ago) Channel 4 News last night: If we don’t test millions every day “we are going to be in a prolonged depression. And I’m using the word depression intentionally. This depression is likely to be worse than the Great Depression of the 1930s. So that will be very harmful to the quality of life, it will cause great hardship for many people, especially poor people. The most worrisome effect of this could be to further exacerbate tensions. When something bad happens people often start to look for someone to blame…to punish. And that impulse could further exacerbate tensions around the world. It could also undermine our democratic institutions. What’s missing right now is a clear idea of how to contain this virus.” Gavyn Davies, Economist, Former chair of BBC and Goldman Sachs partner FT 3 May: “The equity markets are assuming that the storm will blow over very quickly, with GDP growth rates being higher not lower than normal in 2021. On that basis, equities do not look particularly overvalued. In a normal cyclical downturn, predictions for GDP growth are reduced in successive years once a recession becomes inevitable. This is particularly true in the second year after the recession starts, suggesting no early bounceback to previous peak activity. The decline in output becomes persistent, not a springboard for recovery. This more normal pattern underpinned the strong concerns expressed by Federal Reserve chairman Jay Powell last week about the medium-term risks to the productive capacity of the US economy following a very deep recession. Mr Powell also said that the course of coronavirus itself is a new form of economic uncertainty. He is clearly right about this. The grim arithmetic of epidemics strongly suggests that any increase in the R rate significantly above one may lead, sooner or later, to a large second wave in infections that will need to be suppressed.” FT 5 May: “Do not count on a fast global e ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 Warren Buffett bought $358m of preferred shares in USAir in 1989. At one point he wrote down this investment by 75% and spoke of his bitter regret at having placed Berkshire’s money in an industry with such poor economics. He was smarting so much that two years into the investment he said, “Despite the huge amounts of equity capital that have been injected into it, the industry, in aggregate, has posted a net loss since its birth after Kitty Hawk... it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners” (1991 Letter to Berkshire Hathaway shareholders).
Three years after that, with things looking even worse: “I have an 800 number now which I call if I ever get an urge to buy an airline stock. I say, ‘My name is Warren, I’m an air-aholic’ and they talk me down” (speaking to students at Columbia University 1994). Even into the twenty first century he was feeling the sting. In a 2002 interview with The Telegraph he said: “If a capitalist had been present at Kitty Hawk back in the early 1900s, he should have shot Orville Wright.” And yet a few years later, in the 2016, he went back into airlines in a big way, buying around 10% of the common stock of the four largest American airline companies, paying a total of between $7bn and $8bn. And he was caught out again – this time because the economics of the industry were hit dreadfully hard by the Coronavirus and its aftermath as the economics of the industry shifted dramatically when people refused to fly. (He managed to salvage about $6bn by selling all those shares in April 2020). It would be harsh to criticise him for not allowing for the virus-affliction in 2020. But we can all learn lessons – as he did - from the mistake of investing in USAir in 1989. Back then, the appalling economics of the industry were widely known, with massive over-capacity and cut-throat pricing. And USAir was in a particularly weak position vis-à-vis its larger competitors. Why did he do it? The making of USAir In 1937 newly-formed All American Aviation was undertaking daring experiments swooping down its single engine high-wing monoplanes to grab mail packages suspended from ropes or cables strung across two poles (using a hook). By 1939 they were ready to roll out their airmail pick up service from their Pittsburgh hub, across the Allegheny Mountains and down the Ohio River. It wasn’t until 1949 that the firm offered a passenger service in the same region. In 1957 a 31-year old lawyer joined the company, by then renamed Allegheny Airlines, as Assistant to the President and to act as staff attorney. Ed Colodny had spent three years with the regulator, the Civil Aeronautics Board, and so was a game keeper turned poacher; he knew his way around the rules in a highly regulated industry. Over two decades the airline grew through mergers, encouraged to do so by the regulator which was keen to reduce subsidies handed out to industry. By the time Colodny was put in charge of the firm, as CEO, in 1975 the industry consisted of first, 12 major trunk airlines, serving larger cities and longer routes, and second, 12 local service airlines, including Allegheny, which served smaller cities. Colodny quickly acquired the sobriquet “Uncle Ed” around the hangers and offices, as a well-liked and approachable chief. Both longstanding employees and those added through acquisitions appreciated their gene ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 Following Warren Buffett’s announcement that he had sold all the shares in the four American airlines owned by Berkshire Hathaway there was a very negative market reaction, with their prices falling by yet another 10% or so on Monday 4th May. He explained that the economics of the airline industry had changed so much for the worse that the shares were not worth the $7bn -$8bn he had paid for them. He managed to clawback around $6bn
A rational decision “We thought we were getting an attractive amount for our money when we were investing across the airlines business and so we bought roughly 10% of the four largest airlines. We probably paid between $7bn and $8bn. We felt that we were getting a billion, roughly, of earnings in a year (not $1bn of dividends) – our share of underlying earnings was about $1bn. We thought that number was more likely to go up than down over a period of time, but it would be cyclically, obviously. We treated it, mentally, as if we were buying [the whole] business.” Mistake “I was wrong about that business because of something that was not in any way the fault of the four excellent CEOs. It’s a very difficult business. The airline business – I hope I’m wrong – changed in a very major way. It’s obviously changed in the fact that the four companies are each going to borrow perhaps an average of at least $10 - $12bn. Well you have to pay that back out of earnings over some period of time. I mean, you are $10 - $12bn worse off if that happens. They are having to sell stock, and that takes away fr………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 Warren Buffett, speaking a few days ago, advised us to have a far horizon in mind when holding shares and to make sure we had the psychological resilience to be an investor.
Buy for the long term “You shouldn’t buy stocks unless you expect to hold them for a very extended period and you were prepared, financially and psychologically, to hold them the same way you would hold a farm and never look at a quote.” If the company is good, with a sound business, sound strategic position and excellent managerial team then why worry if Mr Market lowers the share price? “You’ve got to be prepared when you buy a stock to have it go down 50% or more and be comfortable with it as long as you are comfortable with the holding. There have been three times in Berkshire’s history when the price of Berkshire stock went down 50%. If you held it on borrowed money you could have been cleaned out. There wasn’t anything wrong with Berkshire when those three times occurred, but if you’re gonna look at the price of the stock and think that you have to act because you think that its going to do this or that…[well] you’ve got to be in the right psychological position." You need the right emotional base “Frankly, some people are more subject to fear than others. It’s like the virus. It ……To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 |
Glen ArnoldI'm a full-time investor running my portfolio. I invest other people's money into the same shares I hold under the Managed Portfolio Service at Henry Spain. Each of my client's individual accounts is invested in roughly the same proportions as my "Model Portfolio" for which we charge 1.2% + VAT per year. If you would like to join us contact [email protected] investing is about making the right decisions, not many decisions.
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