Running a concentrated portfolio is one of the surest ways to win. It’s also the surest way to lose. Moreover, the difference between winning and losing may not be much.
It’s been an interesting two weeks at SCG. Your manager has been public about liking the risk/reward offered on many airline equity investments. It’s only right to acknowledge those public declarations created additional emotional pressure when inevitable uncertainty materialized.
Owning an asset is far different from researching an asset. It’s easy to contemplate a recession, terrorist attack, or outbreak while researching an investment opportunity. For airlines and travel, a researcher would find that even after 9/11 and The Great Recession air travel proved resilient. As shown below, travel demand bounces back pretty quickly.
It’s hard to imagine scenarios worse for passenger demand than 9/11 and/or 2008-2009. That’s easy to wrap one’s head around. Right? Sure, until you own the position and see this:
And what happens when you see headlines about stories about L.A. declaring a state of emergency? See https://www.cnbc.com/2020/03/04/los-angeles-area-officials-declare-local-emergency-confirm-new-coronavirus-cases.html. What then? How does your data feel when a stock chart looks like this:
Or, God forbid you decided to own one of the riskier stocks in the sector and stare at a 40% drawdown in under a month?
How does that historical data feel now that IATA projects $27.8Bn of revenues lost in 2020 just in Asia? See https://www.iata.org/en/pressroom/pr/2020-02-20-01/ . How does it feel to watch conferences get canceled? How does it feel to have anyone with a shorter term time horizon say you’re an idiot for remaining long?
None of that feels like the underwriting felt. It feels scary. It is scary. It’s also not rational. Making matters worse, an investor is able to cut the current pain, and avoid further pain, with just one click of a button. All he/she has to do is sell. That feels so much safer. It’s also a great way to donate profits to Mr. Market.
Fundamentally, an investor is entitled to earn the returns of the business he/she chooses to purchase only when that investor is willing to own the crappy times for the business. An investor is not entitled to return while avoiding risk. Instead, that investor is only entitled to donate return to those willing to suffer.
As Tom Russo has summed up, both the investor and the business must have the capacity to suffer. Running a concentrated portfolio substantially increases the need for an investor to have the capacity to suffer. As a quick aside, Joel Greenblatt mentioned he found letting his winners run to be as, or more, difficult than watching his positions go against him. SCG would have benefited from letting certain winners run longer. That said, we’ve also been fortunate to make some timely exits so the jury is still out on our long term selling record.
If not now, when is this thesis wrong?
One major reason to own airline stocks is a bet that consolidation enables relatively fast responses to demand shocks. COVID-19 has certainly created a demand shock; or at least the perception of one in the US. It’s undeniable that the current quantity of seats demanded will be lower than projected, and will almost certainly see year over year declines. But have the demand and supply curves actually moved to create an industry doomed for failure? Doubtful.
As of today, a bad case scenario would result in 2% of the population dying. That is a lot of people. It’s also approximately less than one year of anticipated seat mile growth. Recently, airlines have managed to keep load factors reasonably stable, which is evidence of rational growth.
It’s not a stretch to think 4 major players could manage a 2% decline in capacity. Moreover, the reduction is unlikely to be permanent given people’s desire to travel. Heck, even now 90% of people are proceeding as planned for Spring Break. See https://skift.com/2020/03/02/nearly-90-percent-of-u-s-travelers-have-yet-to-cancel-plans-due-to-virus-skift-research/?utm_campaign=Daily%20Newsletter&utm_source=hs_email&utm_medium=email&utm_content=84159193&_hsenc=p2ANqtz-85tAqLAorvJy3UYCXoTZpScFaLaC8xeSlOtuSkv7bkvKT0m-XK73LjiiIfQVutz3O_FfDNhhU5EYt-ttBxH7s5JFOFKPcg464bzHsbSDu8bOS6H_Q&_hsmi=84159193 .
But What If They Are Go Bankrupt?
Equity owners of the entities controlling the planes could see a permanent impairment without the industry stopping. All you need to do is look at the time period between 2000-2012 to see the potential devastation. That said, airlines, specifically US airlines, are in a much healthier position going into this potential crisis.
An incredibly bearish argument would say the airlines have 2 months of liquidity before things get really scary.
However, that assumes there are zero revenues, the costs stay almost totally constant, and the airlines cannot mitigate any of the damage. That scenario is highly unlikely. Moreover, if demand falls to zero there are going to be way bigger things to worry about than the health of airlines.
The Most Likely Outcome
SCG is positioning itself to take advantage of further pain. Please note, we hope none happens and pray the human toll is minimal. However, thinking rationally about the current situation, it’s hard to see permanent long term consequences.
Yes, the short term could be painful. Yes, things are scary right now. Yes, it sucks to have a drawdown in a big position. All that said, our view is this virus is here to stay. Accordingly, sheltering in place won’t do anything for most of us. Moreover, most of us will not have our lives impaired. Thus, the probability that Americans decide to incur pain for a meaningful amount of time is low to quite low.
Therefore, we will continue to hold our airline positions and earn the reward liquidity tempts us to sell out of. As stated, the pain is likely to get worse. Potentially much worse. Buckle your seatbelts and put your seatback in the upright position.