Re-Evaluating My Bearish Southwest Airlines Sentiment

Summary

• In April of 2018, I wrote an article questioning how far Southwest Airlines stock could fall during a bear market.
• In that article, I warned that Southwest could fall 40-75% off its peak price, and I suggested Berkshire Hathaway was a better alternative at the time.
• That trade has been very successful. In this article, I re-evaluate Southwest stock in light of the coronavirus, now that the stock is over -30% off its highs.
• I do much more than just articles at The Cyclical Investor’s Club: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »

Source: Pixabay

Introduction

Back on April 4^th, 2018, in my article "How Far Could Southwest Airlines Fall?" I warned investors about the potential downside of investing in Southwest Airlines (NYSE:LUV). It was one of only two bearish articles published about Southwest in the past three years amid dozens of bullish articles from other authors. In that article, I shared the historical price cyclicality of Southwest's stock in this table:

Some of the key factors current LUV shareholders might want to consider are the speed at which the stock price could fall, how deep the plunge could be, and how long they might expect the stock to stay below the price at which it is today. Over the past 45 years, LUV has had nine sell-offs of 35% or more as depicted in the table below:

~Year	~Time until bottom	~Duration	~Depth
1973	4 months	6 months	50%
1974	6 months	18 months	60%
1978	4 months	8 months	37%
1981	4 months	15 months	49%
1984	6 months	18 months	46%
1985	2.5 years	6 years	59%
1994	1 year	4 years	60%
1999	6 months	18 months	38%
2001	8 years	14 years	78%

Click to enlarge

Using this information, along with the fact that LUV's price had risen considerably going into 2018 and I thought that we were late in the economic cycle, I suggested that LUV shareholders could expect a significant decline in the stock price even if LUV continued to grow for three years more (through 2021) before a decline occurred.

Since there doesn't seem too much of a discernable historical pattern with regard to how far LUV might fall in a downturn, I'll provide a price range based on a 40-75% drawdown from its projected peak price. That range is $28.69 to $68.84. It's important to keep in mind that analysts are still very optimistic about LUV's earnings over the next three years and expect its price to more than double during that time period. That means if the drawdown starts sooner than that, this expected price range would be much lower.

LUV's price is currently right in the middle of my suggested range. Interestingly, analysts at the time were projecting LUV's share price would be about $91 by this point in time, nearly double where the price is at today. So, I feel like I did my job on this one regarding warning investors about the danger of the stock's decline.

I went a step further in that original article. Whenever I write a bearish article on a stock, I feel obliged to offer some alternative investment where an investor might put the proceeds of their sale. In fact, I developed a whole rotational strategy around this approach as a way to gain 'free shares' in businesses that we like, but that may have gotten too expensive or subjected to big cyclical drawdowns like Southwest has traditionally been subjected to.

The way the strategy works is one rotates out of the expensive and/or cyclical stock, in this case, LUV, and into a more defensive stock or ETF. In this case, in my original article, I suggested Berkshire Hathaway (BRK.A) (BRK.B) as a reasonable alternative. The idea was that Berkshire's stock price would not fall as far as LUV's during a downturn and that a spread would open up between the two stocks wide enough that eventually the investor who rotated out of LUV and into Berkshire could rotate back in and purchase more shares than they originally owned at no extra cost. As I summed up in my original article:

I feel fairly confident one could rotate into Berkshire right now, and have an opportunity to rotate back into LUV within the next few years and gain 20% more shares at no extra cost.

Here is how the two stocks have performed relative to one another since my original article:

Data by YCharts

An investor who rotated out of the stock back in April of 2018, and now rotated back in would own ~27% more shares than they started with. So, if they sold 100 shares back in 2018, they could now buy 127 shares without spending any extra money. For investors who are bullish on LUV's long-term prospects who may have rotated into Berkshire, congratulations, you can now rotate back in and be 27% richer than you would have been by continuing to hold LUV's stock over this time period. I now consider this rotational idea complete.

LUV wasn't the only stock I warned about in 2018 and early 2019. In all, I suggested this rotational strategy for about 30 stocks. A few of those I changed along the way while they were about even with my suggested alternatives so their free share gains were zero (break-even), but for the more than two-thirds that have been completed so far, the results have been very good:

Ticker	Free Shares Gained	Ticker	Free Shares Gained
CMI	53%	EMR	30%
STT	38%	GD	50%
MGA	40%	ROK	35%
MMM	32%	ETN	28%
NOC	47%	CCL	33%
FDX	41%	PNC	23%
TIF	29%	UTX	29%
CAT	37%	DE	34%
BA	20%	GWW	0%
PAYX	0%	NKE	3%
AXP	12%	BBY	0%

Click to enlarge

LUV will now join this list. These were all publicly documented ideas made in real-time on Seeking Alpha. There are currently 9 ideas that I'm still tracking, which I update quarterly. You can read the last update from January here if you are interested.

When will LUV be a 'buy'?

The above was written for the audience of my rotation series, but I'm sure there are many more investors who are interested in what might be a good price to buy Southwest stock. I covered some of this in my last Southwest update about a year ago in my article "Here's The Price I'll Consider Buying Southwest Airlines."

Putting all this together I'll address three different potential audiences. The first audience is shareholders who were long-term bullish on Southwest, but who followed my suggestion and rotated into Berkshire Hathaway back in April. For them, I would still be looking to rotate back in when an ~20-30% share gain opportunity occurs. I'll write a blog update when that happens.

For long-term shareholders who really love Southwest and never plan to sell, I would hold off adding any shares until the stock is approximately -60% off its highs.

For cyclical investors like me, waiting in cash or some other defensive investment who are looking for a good buying strategy for Southwest, I think buying a 1/4 position after a -35% decline with no more than a 1% portfolio weighting, which would be a price of $43.24, seems reasonable. But waiting for a -60% decline before really loading up on the stock with the other 3/4 position is a good idea. This is a way both to play the secular uptrend we've seen the past few years along with the uncertainty of how a recession would affect the stock.

Right now, we are knocking at the door of that $43.24 price and the stock is down over -30% off its highs.

Data by YCharts

I think the question now becomes, how does the new coronavirus factor into this? We have seen already in late 2018 that a -20% correction in the wider market roughly corresponded to a -35% decline in LUV's stock price. That was without the coronavirus and only taking into consideration that higher interest rates would trigger a recession. Today, I think even with lower interest rates, the odds of recession or serious economic slowdown are at least equal to what they were in late 2018, the last time the stock traded near these levels.

To make matters worse, the nature of the virus and its effect on travel clearly directly impact Southwest's business. Once it was clear the virus had reached Italy a couple of weeks ago, I sold my Ryanair (RYAAY) stock because it was clear it would be directly affected by the virus. My thinking is exactly the same for Southwest's earnings, now that the virus is spreading in the US. We absolutely know with certainty this will affect earnings this year. There is also a very high probability it will affect the wider economy as well and earnings growth will be negative. For these reasons, I would not be a buyer of the stock here, and instead, I would wait for a -60% decline from highs before I would consider buying the stock. (And I now limit my portfolio weightings for initial purchases to 1-2% instead of up to the 4% I noted in my last article. So if I eventually buy, it would be a smaller position.)

That works out to a potential 'buy' price of $26.79. I want to be clear that this is not a 'target price' that you will find from most analysts, which is either an attempt to share the intrinsic value of the stock or to predict what the stock price will be in 12-18 months. Instead, it is a price that I think has a greater than 50% chance of occurring over the next year or two, which also includes a margin of safety based on historical price declines. Historically, buying at this point during past down cycles would have beaten the S&P 500 over the following five years. (Read my previous article from January 2019 for the breakdown of those historical returns.)

If it becomes clear that the coronavirus is devastating travel completely, I would hold off buying this stock, or any airline stock, until a government bailout is announced. I'm not predicting it will be this bad, but I won't buy blindly at $26.79 if we are in the middle of a devastating pandemic. Remember, this stock took 14 years to recover from the 2001 decline. There will be other beaten-down stocks that will recover more quickly from a downturn than this one.

Conclusion

My 2018 rotation was a success with Southwest, but I think the price is likely to fall much farther from here. For investors who like the long-term prospects of the business who are waiting with cash to buy the stock, I wouldn't get interested until it's in the mid-$20s price-wise, which is what we would expect from a moderate recession. If the coronavirus is clearly devastating the industry and wider economy in a few months, wait until the government steps in with a bailout. The odds are very high that will happen, given the unusual nature of the cause of the decline.

Analyst’s Disclosure: I am/we are long BRK.B. 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.