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Berkshire Annual Letter (Part 8)

Richard Branson, the owner of Virgin Atlantic Airways, was once asked how to become a millionaire. He had a quick answer to it: “Start as a billionaire and then buy an airline.”

Warren Buffett decided in 1989 to put that statement to the test by investing $358 million in a 9.25% preferred stock of USair. It turned out that Warren’s analysis of USair’s business was both superficial and wrong.

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2 Mistakes That Warren Buffett Made

Late in 1993, Warren Buffett sold 10 million shares of Cap Cities at $63. At the end of 1994, the price was $85.25, a “loss” of $222.5 million.

This was a “repeat offence” because Warren Buffett had previously sold Cap Cities at $4.30 per share during 1978-1980 and then bought them again for $17.25 in 1986.

However, the top mistake of the year went to the $358 million purchase of USAir preferred stock, made five years ago.

In the analysis of the purchase, Warren Buffett had failed to consider the problems that would affect a carrier whose costs were both high and extremely difficult to lower.

In the beginning, this was not so much a problem as the airlines were protected from competition by regulation. They could absorb high costs by passing them on to consumers using high prices.

Even when deregulation came, the impact was not immediately felt as the capacity of low cost carriers was too small at first. But as the capacity of low cost carriers increased, the high-cost airlines were forced to cut their fares to stay competitive.

This poses serious considerations to their long term viability.

As it turns out, Berkshire’s $358 million worth of preferred stock in USAir was written down to $89.5 million, a loss of 75%.

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In 1991, Midway, Pan Am and America West from the airline industry all entered bankruptcy. (Stretch the period to 14 months and the list includes Continental and TWA.)

Warren Buffett does not like the airline industry at all.

Despite the huge amounts of equity capital that have been invested, overall, the industry has posted a net loss since its birth after Kitty Hawk.

The problem is made worse by the fact that the courts have been encouraging bankrupt carriers to continue operating.

These bankrupt carriers can temporarily charge fares that are below the industry’s costs because they don’t incur the capital costs faced by their solvent peers. These losses are then funded by selling off assets.

The low fares by bankrupt carriers contributes to the toppling of previously-marginal carriers, making it unprofitable (and spelling doom) for everyone.

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