Beyond The Headlines
Three Times is the Charm
Only earlier this year, someone I know told me – “What are you worried about? Airlines don’t go bankrupt anymore.” My ears perk up when I hear a statement shared with so much conviction. I don’t recall ever holding shares of a company that went bankrupt. I held tickets of three bankrupt airlines in my life, though, and the third one was only this year soon after my colleague’s confident declaration. Why do businesses go bankrupt anyway, and how can we avoid owning them?
I held the first ticket of a bankrupt airline exactly around the time I met my future mentor, boss, and now business partner, Mr. François Sicart. We had a morning meeting scheduled in Paris; I was still a graduate student at the time. I was hoping to go see my family in Poland for the holidays. As luck would have it, the airline went bankrupt only days before our appointment and my travel — I lost my ticket. My student budget didn’t have much wiggle room for that kind of a surprise, but it was a priceless lesson nonetheless.
I had the hardest time finding a reasonably priced alternative so last minute during a busy travel time. The second most desirable option would have me travel out of Paris, missing my long-awaited meeting with Mr. Sicart. I didn’t know yet, but our conversation was to lead to an internship opportunity and eventually to a wonderful career I have enjoyed ever since. I went with the next option, a mode of transportation leaving Paris only hours after this very memorable meeting. Right after our conversation, I ran home, changed, and chased a 24-hour bus back to Poland instead of a low-cost flight with an airline that was no longer there.
This experience made a lasting impression on the mind of a newly minted value investor who was trying to tame his excitement about the stock market with a reasonable dose of caution to balance it out. A bankrupt airline will do that to you!
Holding shares of a company that goes bankrupt is a zero outcome. You lose all in that particular investment. It’s something we do our best to avoid. I haven’t owned one bankrupt company, but that’s not because I was lucky. It’s a very disciplined choice of avoiding certain businesses that have a very real chance of going completely bust.
Why would anyone be interested in those companies, you could wonder. Some of them make a miraculous comeback once in a blue moon and can generate eye-popping returns, while the alternative worst-case scenario is a zero. I vividly remember the near-bankrupt companies during the Great Financial Crisis of 2008-2010. Their outcomes were rather binary: great or terrible.
Some argue that you could own a big number of those near-bust duds, and then some of them will possibly survive. We won’t argue against it, but it’s not a strategy for our stomach and quality of sleep. To me, the biggest risk is the compromise. If you let a handful of potential zeros into the portfolio, you run a risk of eventually holding all your investments in such stocks. The nature of most crises happens to bring all weak companies to their knees together at the same time. I have no interest in seeing how such a portfolio would look in March 2020, March 2009, or any previous market freefall.
Now and then, some investors see their stocks drop 10%-20%, even 50%. This might be too much to stomach at times. The price drop can be as much a paper loss from which one can recover and see further growth as much as a sign of further trouble. A bankrupt company is quite a final loss, a permanent loss.
To be fair, there are companies that almost go bankrupt, and their stocks drop 90% or more. To me, it is as bad as a zero. It is a very hard place to be and equally hard to recover from.
With bankrupt companies, it’s a lot like with Charlie Munger’s frequently shared goal: “All I want to know is where I’m going to die, so I’ll never go there.” If you know what kind of a company can go bankrupt and avoid them, you’ll be just fine. Charlie will celebrate his 100th birthday next year, so if he can do it, adding decades to his life, we can definitely attempt the same, extending our investment results.
A company goes bankrupt when it can’t handle its debt anymore. There are laws in place that govern how the assets and business of a company will be used to clear its debts. The debt holder, who lent money to the company, might recoup some of the committed capital. What happens with the shareholder? You guessed – if you hold common stock, you will like get zero. You might see some formerly bankrupt companies re-emerge even with the same name and logo, but don’t be fooled; it’s a whole new set of shareholders that get to own it. The previous common stock gets canceled. Ouch!
I held tickets of three bankrupt airlines when they went bankrupt. I flew with other airlines that had gone bankrupt since. It’s the nature of that particular business. Why is that?
Airlines often have high fixed assets funded with substantial debt and are not very flexible. They have high fixed costs, which makes them very vulnerable during any downturn (including a global pandemic). It’s also a cyclical business since a plane ticket is a discretionary purchase that travelers are readily willing to forego and postpone. Therefore, the demand is volatile and can vanish for long enough to get the airline in trouble. On top of that, the industry suffers from limited customer loyalty and a highly price-sensitive buyer. It’s also a highly regulated and very competitive business. With any unfortunate combination of events, airlines are bound to either go bankrupt or hope for governmental help.
Now, if you flip this logic on its head or invert and wonder what kind of company has minimal if any, chance of going bankrupt, you will see a very different picture. It’s a business with no or limited or manageable debt; it has sustainable profits and a loyal customer base. Customers are not too price-sensitive either. Ideally, you’d like to see low fixed costs so that the bigger the business grows, the higher the margins get, and profits flow with preferably limited additional capital needs. Lastly, if the capital gets reinvested, it produces higher returns and is incremental to margins.
Those businesses exist, but they aren’t usually available at bargain prices. It takes patience and discipline to scoop them up when an opportunity arises, and it eventually does.
Three times is the charm – I wrote down jokingly when I found out another airline went bust as I readied to travel. I knew that an idea for an article was born!
I purchased and held these three tickets because I had limited choice. Either it was the only connection that made sense or the only ticket price that worked for me. It was a necessary risk at the time but a very limited risk, an inconvenience rather. When it comes to buying stocks, “no” is always a valid choice.
This time around, a twenty-year-old regional airline failed to agree with the unions and collapsed under the weight of the debt, seeing no return to positive cash flow in the near future. I only found out about its demise days before the flight. We chose an alternative and filed a claim with the credit company to get our cash back. I keep my fingers crossed, but I don’t lose my sleep over it, and anyway, the experience inspired this article and brought back some memories – made it worth it!
I’ll keep flying and buying airline tickets, and I might come across another dud again, but I made a commitment a long time ago that I’ll do my best to avoid absolute zeros investing. It’s good to remember how those zeros can come about and then head the other way anytime one appears in sight. Will some of them experience a miraculous turnaround? Maybe, but again, we won’t lose our sleep over it, wait and hope for the best.
The information provided in this article represents the opinions of Sicart Associates, LLC (”Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.
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