In January Warren Buffett ventured into an area of the market that he has shied away from for most of his inventing career. As the market has become very expensive with the average P/E ratio on the S&P 500 index above 28 times earnings, investors have been searching for value.
It seems that Mr. Buffet has found value in the airline stocks, a market sector that has been difficult to say the least. Airlines have suffered their ups and downs over many years and most of the big moves have been on the downside. Terrorism, volatile energy prices, weak economic conditions and a host of issues have weighed on the prices of airlines shares. Additionally, U.S. airlines compete on a global landscape where many others have a distinct advantage, the support of other governments who view the survival of their national air transportation companies as a matter of national security.
With Buffett at the tender age of 86, each new trade could be his last. He has traditionally shunned airlines but that seems to have changed and I have to wonder whether the fundamentals of the business is better these days or if the prices are compelling compared to other companies that trade on the stock market in the U.S.
Are airline stocks cheap?
In November 2016, Warren Buffett surprised the market when he bought shares in the four largest U.S. airlines. Since then, all four have moved higher likely because of his purchases and the path of least resistance in the overall stock market.
On November 1, 2016 American Airlines (NASDAQ:AAL) was trading at the $39.80. and it has rallied to $45.35 per share since, an increase of 13.9%. Trading at a trailing 12 month price to earnings ratio of under 10, AAL remains cheap compared with the rest of the market.
United Continental (NYSE:UAL) has appreciated from $56 to $71.87 since November 1, climbing over 28% over the past three months. With a trading 12 month P/E of around 10.7 times earnings, the valuation of UAL is cheap compared with many other companies that trade on the stock exchange.
Southwest Airlines (NYSE:LUV) has given Buffett plenty of love since November 1 as the company's stock has rallied from $39.68 to $53.18, a rise of over 34%. The P/E of Southwest Airlines is the highest of the four trading at around 15 times trailing 12 month earnings.
Meanwhile, Delta Air Lines (NYSE:DAL) is the cheapest of the four stocks, trading at a P/E of under 9 times 12 month earnings. DAL shares have increased from $41.88 in November 1 to $48.23, an increase of around 15%.
All in all, the Oracle of Omaha has done quite well on his foray into the airline sector.
Trading close to the top of the range and lots of risk in this sector
Except for Delta, all of the four airlines are trading near their highs. At the 2013 annual meeting of Berkshire Hathaway shareholders, when DAL was trading below the $20 level he dismissed the sector as a "death trap for investors." However, lower oil prices, the lack of other cheap companies on a valuation basis and his ownership of Precision Castparts which is a major parts supplier to the airline industry, have caused him to jump head first into the sector. One of Buffett's favorite jokes over the years has been, "How do you become a millionaire? Make a billion dollars and buy and airline" which made the market wonder why would he venture into this shark infested sector. One of the reasons could be that his deputies spurred adding the companies to the portfolio based on valuation and the lack of other investments on which to spend their boatloads of cash.
Airlines are a tough business, and the current political and economic landscape around the globe is not supportive of the industry. The fact is that one terrorist attack will send these stocks reeling lower and a spike in the price of oil could do the same. Last summer, the U.S. State Department warned travelers about traveling to Europe and under the current administration, warnings and prohibitions on travel could become more of an issue in the months ahead.
Meanwhile, the price of crude oil has doubled from last year at this time and jet fuel prices are higher.
As the weekly chart of NYMEX crude oil highlights, the price of the energy commodity has moved from $26.05 per barrel on February 11, 2016 to over $52 per barrel on February 7, 2017. Airlines were cheaper last year at this time but Buffett caught the majority of the rallies as all four airlines have posted some pretty impressive gains since he bought.
When it comes to airlines, the new administration could mean a rocky road in the months ahead in the sector that Buffet has always viewed as a "death trap."
The President and airlines
The new Trump administration in Washington, DC, faces some issues when it comes to the airlines. The Republican administration and Congress believes in free market capitalism but at the same time, President Trump has argued that foreign competition and trade deals have put the United States behind the eight ball when it comes to competing on the international scene. The President of American Airlines has been lobbying the administration over routes by foreign competitors. Meanwhile, changes in immigration policy could impact airlines negatively in the months ahead. Therefore, airlines could be at risk when it comes to trade agreements, tariffs, and changes in policies that are certain to occur under the new leadership.
Moreover, a deterioration of the U.S. relationship with Iran could cause increased volatility in oil prices. While U.S. production is on the rise and inventories are climbing, any increase in rhetoric or violence in the Middle East could likely cause the price of the energy commodity to rise increasing the crucial cost of goods sold input for the airline industry.
Crude oil could hold the key
As the critical cost for airlines, the price of jet fuel is one of the chief determinants of ticket prices for air travel. Any rise in the price of oil from the current level would likely decrease demand for air travel. Additionally, any terrorist events in Europe or around the world will cause U.S. travelers to curtail travel plans.
It is likely that oil holds the key for the future of earnings for U.S. airlines. A long position in airlines amounts to a short position in crude oil when it comes to potential appreciation from what are already levels close to all-time highs in three of the stocks and multiyear highs in American Airlines.
A suggested strategy for airline investments
For those long airline stocks, a good hedge could be a long position in the oil market. One of the biggest risks facing the airline industry is the price of jet fuel which is a function of oil prices.
Crude oil has been trading in a range from around $50 to $56 per barrel since December 1 on the nearby March NYMEX futures contract.
As the weekly chart of NYMEX crude oil futures shows, weekly historical volatility has declined from over 60% last year at this time to around the 12.4% level. Lower volatility makes the prices of options cheap compared to where they have traded over recent months. Implied volatility is the chief determinate of the price of an option and implied volatility is often a function of historical variance. Therefore, with option prices in oil at a fraction of where they were last year and over recent months, the purchase of a call option on crude oil could serve as an effective hedge for long positions in airline stocks at this time. Moreover, huge inventory increases over past weeks are likely to cause the price of the energy commodity to drop to the bottom end of the trading range. The American Petroleum Institute reported a mammoth build of 14.227 million barrels on Tuesday, February 07 which will likely cause selling in the future market over the course of the week making those call options on oil even cheaper in the short-term.
Somewhere, deep in his investment subconscious, Mr. Buffett must have some degree of discomfort with his positions in the airline stocks. While they certainly offer value compared to other stocks and industries these days, the risk remains high. I would not be surprised if Warren and his investment gurus have some hedges on in the oil market on the long side to cover the risk of a sudden shock in the petroleum market given the highly volatile Middle East and the current state of the U.S.-Iranian relationship.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.