In addition to being perhaps the most successful long-term investor in history, Warren Buffett has put in a multitude of memorable aphorisms during the writing of dozens of annual Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) shareholder letter.
One of his most famous statements goes back to the shareholders’ letter of 1986, when Buffett wrote: “Our goal is more modest: we simply try to be scared when others are greedy and to be greedy only when others are scared.” He repeated the point in another shareholders’ letter nearly two decades later, saying that if investors feel compelled to try to get time in the market, “they should try to be scared when others are greedy and greedy only when others are scared.”
Many value investors probably believed they followed Buffett’s advice by buying flight shares to hand over fist when they fell between February and April. On average, the shares of the four largest US airlines – American Airlines (NASDAQ: AAL), Join airlines (NYSE: DAL), Southwest Airlines (NYSE: LUV), also United Airlines (NASDAQ: UAL) – has lost about two-thirds of its value since mid-February.
If so, it must have been a shock to learn last Saturday that Buffett sold all of Berkshire Hathaway’s significant flight investments with a loss in recent months. (In addition, he did not make major new stock acquisitions despite the market’s major fall in March.) What gives?
The advice is about the stock market
The first thing to note about Buffett’s tips on greed and fear is that he talked about the stock market: not individual stocks. In his 1986 letter, Buffett said he bought bonds with Berkshire’s insurance float rather than shares – even though he thought the bonds were mediocre investments – because shares had been driven to irrationally high levels. Buffett had to do something about the money, and bonds served as a relatively safe placeholder while other investors were greedy with stocks.
Buffett was even clearer in his letter from 2004. Just a little before the quote about greed and fear, Buffett pointed out that most investors’ best strategy would be to buy and hold an index fund. He then advised investors that if they could not get themselves to just buy and hold, they would try to be greedy when others were scared. He probably still talked about buying an index fund – not investing in individual stocks.
Buying an index fund when the market drops significantly is a strategy with good odds. There is a certain level of security in being diversified across the economy. (It’s still not foolproof: the market dropped 12% in 1929 and another 28% in 1930. It may have seemed like a good buying opportunity, but S&P 500 then 47% fell in 1931 and fell another 15% in 1932!) In contrast, shares in individual companies may decline as their profit opportunities have been permanently changed for the worse. At the limit, this can lead to a company going bankrupt and the share being canceled.
What goes down doesn’t always go up again
Warren Buffett is aware that this applies to the aviation industry. He spent the greater part of two decades warning investors against investing in airlines, noting that they repeatedly destroyed investors’ capital for a century. (Of course, he changed his mind several years ago and built up major stakes in American Airlines, Delta Air Lines, Southwest Airlines and United Airlines.)
Berkshire Hathaway’s investment in American Airlines stock was always somewhat strange given the airline’s high debt and margins below average. Nevertheless, the other three airlines had solid results for free cash flow production before Berkshire became involved. Given the structural changes in the US aviation industry (primarily consolidation), Buffett was not entirely irrational to believe that airlines had matured into high-quality companies.
But as Buffett wrote in Berkshire Hathaway’s 2001 Newsletter, “… [Y]You should only find out who is swimming naked when the tide goes out. “The tide has gone out in a big way for airlines in 2020. Demand has practically evaporated. The result was that even industry stalwarts like Southwest and Delta – which have earned consistently high margins in recent years – lost money last quarter and support even more Bigger losses ahead: American and (to a lesser extent) United have had more mixed jobs in recent years and are even worse now.
Buffett’s recent investment in and out of flight shares can best be explained in two sentences from Berkshire Hathaway’s 1987 shareholders’ letter: “Our goal is to find an outstanding business at a reasonable price, not a mediocre deal at a good price. … Of course, Charlie can and I might be wrong to read the basic economics of a company. “Airlines seemed to be high quality companies in most of the last few years. Today, they seem much more speculative in nature, which makes it natural for Buffett to admit his mistakes and sell Berkshire’s airlines.
Channel greed wise
As I wrote last weekend, I think Warren Buffett is unnecessarily pessimistic about the future of the aviation industry. As a result, I decided to double the shares of Delta Air Lines and Southwest Airlines last month. Both airlines are currently facing severe headwinds, but I believe that investors (including Buffett) underestimate their ability to adapt if demand remains virtually non-existent for an extended period.
However, I have learned from Buffett that being greedy when the market is scared does not mean buying terrible. The money I used to increase my investment in Southwest Airlines stock came from selling American Airlines shares at a loss – even though America’s stock price has fallen more than Southwest. While I had been optimistic about the turning potential of Americans, it will have trouble navigating the current crisis successfully because of its huge debt burden.
More generally, while the market was selling strongly in March, the second week in April it was back close to last summer’s levels. There may still be some bargains in the stock market, but investors need to be very careful. Most of the stocks that are still nursing large losses probably deserved a big drop.