Prominent value investor Warren Buffett has taken a stake in the airline industry, and investors can also gain diversified exposure to the industry through a sector-specific exchange traded fund.
On the recent webcast (available on-demand for CE Credit), Why Buffett Changed His Mind About Airlines, Frank Holmes, CEO and Chief Investment Officer of U.S. Global Investors, explained that the airline industry enjoys a solid economic moat where barriers to entry in the domestic airline industry are high and there are massive hurdles to building new airports, which allow current companies to maintain a competitive advantage.
The advantages that major airlines enjoy have allowed companies to reap revenue growth and free cash flow growth that have been steadily improving since the financial crisis. The Bloomberg U.S. Airlines Index has shown a 10.22% 1-year revenue growth as of the end of September, compared to the 4.99% revenue growth in the Dow Jones Transportation Index. Additionally, domestic airlines are expected to see their greatest free cash flow in years.
Now, with Warren Buffett’s investment of over $1.2 billion into American Airlines, United Continental Holdings, Delta Air Lines and Southwest Airlines, airline stocks are taking flight. The move was a shocking reversal for Buffet, whom has shunned the industry for decades following a volatile investment in U.S. Airways in 1989.
In a survey of financial advisors attending the webcast, 85% indicated they were bullish on the sector, compared to a 15% of respondents indicating a bearish outlook.
Nevertheless, the industry boasts solid fundamentals that may further support growth. For instance, airliners have gone through a period of consolidation that created more efficient carriers. Meanwhile, 2 million people fly in the U.S. every day, supporting ongoing demand.
Supporting the rise in revenue growth, many carriers are adopting ancillary revenue streams, such as including thinner seats to increase capacity, improved baggage handling and adopting priority boarding, among others.
The global airline industry is also growing as an expanding global middle class has increased discretionary money to spend on traveling. In 2009, the global middle class included about 1.8 billion people. The global middle class is projected to expand to 3.2 billion by 2020 and 4.9 billion by 2030. The expected rise in demand is already causing some shortages, with Boeing looking at a 7-year backlog in production of airliners.
From a valuation standpoint, airline stocks are among the cheapest options in the U.S. industrial sector and broader U.S. markets. Holmes pointed out that low-cost carriers show a price-to-earnings ratio of 9.7, The U.S. Global Jets ETF (NYSEArca: JETS), the lone dedicated airline ETF, currently trades at a 9.64 price-to-earnings and a 2.09 price-to-book. In contrast, the Industrials Select Sector SPDR (NYSEArca: XLI), which tries to reflect the performance of the S&P Industrial Sector Index, has a 19.32 P/E and a 3.78 P/B and the broader S&P 500 Index is trading at a 19.37 P/E and a 2.71 P/B.
JETS follows a type of smart-beta index that screens for multiple fundamental factors, including cash return on invested capital (CROIC) with additional inputs based on sales per share growth, gross margins, and sales yield. The ETF includes a hefty tilt toward airlines, but it also holds aircraft manufacturers and airports & terminal services.
The airline ETF also takes a modified weighting methodology that overweights 12% in the top four domestic airlines, followed by the smaller 4% tilts toward the next domestic airlines, 3% in the next domestic airline companies and 1% in top 20 foreign airline industry companies.
Financial advisors who are interested in learning more about the airline industry can watch the webcast here on demand.