Airlines and Indices
Value investing requires an in-depth understanding of a company’s economics. In this article, Roger Montgomery looks at Virgin Australia Holdings.
Frequently, value investors focus only on the ‘value’ part of the eponymously labeled investment philosophy. Absorbed in calculations as they inevitably become, many investors fail to step back and ask if the business is of sufficient quality to be included in a portfolio in the first place.
Equally disturbing is the focus on the index. Not only is the rise and fall of the All Ordinaries reported on a daily basis but most of the research reports examining returns available to shareholders focus on the gains and losses of the broader indices. This, as you will see, is folly.
Our approach is relatively simple and it is one we advocate for your own investing. If we aren’t happy to own the entire business for a decade, we won’t be comfortable owners of even one share for just a few minutes. In other words, because we aren’t in the business of betting on the rise and fall of stocks, we need the economics of the business – measured over years – to justify a purchase and estimate a valuation.
Back in 2010 on the Sky Business network, Peter Switzer asked me whether I thought the hiring of John Borghetti – a highly regarded manager and business leader – as CEO would make me change my mind about Virgin Australia Holdings. With his exceptional experience in the industry, would I be willing to concede that the fortune of the airline had improved? With the greatest respect to Mr Borghetti, I noted that it did not matter how hard he rowed – indeed he could be an Olympic rower – the boat he was paddling had an irreparable leak. A whopping great hole in the side of the boat would stymie the efforts of even the expertise of Mr Borghetti.
Peter replied with words to the effect of, “Thanks for that Roger… Coming up after the break, Mr John Borghetti…”.
Cue uncomfortable greeting as John replaces me in the guest chair on set.
Despite the discomfort, no apology should be required, because John knew that he would indeed need to produce a herculean rowing effort in order to keep the tide of the business’s economics at bay. Warren Buffett once proffered, “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” And this month, Virgin’s latest performance and trading update revealed that any CEO of an airline might have more success holding back the tide than changing the economics of the airline business.
This is not a recommendation to buy or sell the shares of Virgin or any airline but what I hope to achieve is the transfer of an understanding about how to go about appreciating the economics of a business as it relates to the owner’s relationship with it.
Exactly what does that mean? It means before buying any business, you must understand what the real returns to an owner are. Such an understanding of course need not concern the speculator or market ‘trader’ who merely wants to purchase any stock that is going up. His activities are tantamount to speculation and are as far removed from investing as the night is removed from day.
You may also ask why any such analysis is required when dividend yields, price to earnings ratios, sales and profit forecasts are so ubiquitously offered by any number of desk-bound airline experts all willing to encourage you to compare their understandings of load factors, passenger yields and even seat densities?
The reason only becomes obvious when it is highlighted. The nexus between ownership of a business and the economics of that business are broken by the stock market itself. An individual who owns 5000 shares of BHP does not, over any memorable period, experience what it is like to actually own BHP. The stock market makes sure that distracting rising and falling share prices divert the focus from profits and capital expenditure. But there’s more…
Consider the company that perpetually dilutes its owners by raising fresh capital for acquisitions. The shareholder receives a prospectus in the mail inviting him to participate by, for example, taking up an entitlement to 15,000 additional shares at a discount to the recently traded price. This clearly seems like a delightful turn of events and the shareholder gladly stumps up the cash. But when aggregated, the additional equity may massively dilute the owners, the returns, or both – and the effects won’t be felt until well down the road and perhaps even after the CEO and board have all been turned over.
distant memory and you are now earning less than bank interest.
But just before you get too depressed, remember that money you borrowed in 2003? It was $139 million. You may have hoped that the earnings of the business have helped to pay off that debt. Well here’s a shock for you: you now owe the banks $1.7 billion. Yes, true, that is now their problem but you would have expected that borrowing money would lead to growing earnings and returns.
In this case it hasn’t.
And why? Because the business is an airline – Virgin Australia Holdings. And the economics of airlines change little… and rarely for the better.
Capital intensive, labour intensive, irrational competition, a price taker for inputs and commoditized product offerings means measures such as Load Factors, Passenger Yields and Cost per Available Seat Mile (CASM) are about as useful to an investor as a microscope is to an astronomer.
Looking at businesses by studying their economics as I’ve described here has enormous and favourable implications for investors willing to consider the unconventional approach.
Today’s column, using Virgin Australia Holdings as an example, will attempt to do two things. Firstly, bring the economics of a business back into the decision making phase of investing, and secondly, reveal that Virgin’s latest woes are symptomatic not of one-off special circumstances but of the unchanging structure of the industry it operates in.
Let’s suppose that the year is 2003 and I ask you to consider an information memorandum to invest $184 million in a new business. I’ll run it for you. Write a cheque for $184 million and to make sure we have enough to get going, let’s run down to the bank and borrow $139 million.
One year later…
After a year in business suppose I report to you the first year’s profit of $110 million. Given you invested $184 million, I suspect you are delighted with the 59% return on your funds after one year. Encouraged by these early returns, let’s propose you leave me to run the business for you for the next decade and you return in January 2013 to receive reports on the progress of the business.
The first piece of news you receive is the fact that the profit has fallen. In fact for the year ending 30 June 2012, the profit was $43 million – less than half the profit generated a decade earlier. For 2013 the guidance is expected to be a loss of approximately $30 million provided so-called ‘one-offs’ are excluded. Because you own the business outright, ‘one-offs’ feel like real losses to you so you request that I report the totals including the one-offs. OK then, FY13 might be a loss of about $100 million.
Not good news. The story however gets worse. You might recall that back in 2003, you made a capital contribution of $184 million to kick the business off. Since then however you have made additional contributions directly in the form of capital raisings and indirectly through the retention of earnings. All up you have increased your contribution to more than $900 million. And remember, your profits have now more than halved. Even though you have been tipping more and more capital into this venture, the returns have been declining precipitously. That 59 per cent return on equity is but a
The approach won’t help you pass your CFA examination but as a reliable, long-term money making exercise it is without peer.
Ben Graham, the intellectual dean of Wall Street, noted that in the long run the market is a weighing machine – i.e. that price follows the economic performance of the underlying business. If we take a look at the share price of Virgin we observe that in 2003/04 the share price was above $2.00. Today it languishes below 45 cents.
An investor in Virgin shares would have experienced a proportional economic calamity over a decade as the individual who owned the entire business. This is why an investor unwilling to own the whole business for ten years shouldn’t own a little piece of it for ten minutes.
It is useful to keep in mind that the index is populated with many such business – large, mature, but mediocre businesses that have added little or no economic value over a decade.
Now recall the popular investing advice that implores you to invest for the long term. How often have you been told to simply invest for the long term? How often have you proffered this advice to your own clients? Time is the friend of the extraordinary business but the enemy of the business with poor economics. The longer you remain invested in a business with wealth-eroding economics, the more you will lose – be it opportunity or money or both.
As Virgin’s economics and share price over the last decade demonstrate, the relationship between long run share prices and a business’s economics is highly correlated. If you can identify businesses with superior economics, you should be able to identify the businesses that will produce superior long-run share price performances.
This article was written on 9 August 2013. All share and other prices and movements in prices are to this date.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
