Investors get it wrong sometimes. And I got it way wrong with my pick for the best ETFs for 2020: the U.S. Global Jets ETF (NYSEARCA:JETS).
As I write this, JETS has been almost exactly halved so far in 2020. It has been one of the worst exchange-traded funds, not one of the best ETFs. That doesn’t seem like a surprise in this environment.
The fund’s top holdings are the four major U.S. airlines, which combined account for nearly 50% of the portfolio. And airline stocks have been among 2020’s worst performers, along with energy and retail names.
It’s tempting to blame the decline on the spread of the coronavirus from China, which has grounded flights worldwide. It’s similarly tempting to view the ETF, at essentially half-price, as an even better buying opportunity.
After all, the long-term tailwinds (pardon the pun) that supported the industry in December 2019 should return in the future. A $2 trillion stimulus package from the federal government will provide near-term relief.
But this crisis has reminded investors of the risks in the airline operating model. And those are risks that, simply put, I should have seen. I got this one wrong.
And the reasons I got it wrong with the JETS ETF at $31 remain significant concerns with the fund below $16.
The Industry Changes
The long-term underperformance of the airline sector is well known. Southwest Airlines (NYSE:LUV) is the only major U.S. carrier to have avoided bankruptcy — and avoided wiping out its shareholders.
No less than Warren Buffett, the legendary head of Berkshire Hathaway (NYSE:BRK.A, NYSE:BRK.B) spent years warning investors away from the industry. In 2007, he wrote that “a durable competitive advantage has proven elusive ever since the days of the Wright Brothers.” Seventeen years earlier, he argued that the commoditized nature of the industry meant “it’s impossible to be a lot smarter than your dumbest competitor.”
Of course, Berkshire famously entered the sector in a big way in 2016, taking stakes in four U.S. airlines. And as I wrote in December, in choosing JETS for the Best ETFs for 2020, that shift made some sense.
Destructive price wars had ended. Airlines were focusing on profitable travel — and shareholder returns. Meanwhile, younger generations clearly were more keen on travel, with a clear and consistent preference for experiences over possessions. And airline stocks were cheap: the four major airlines traded, on average, at around 8x earnings.
The case for airlines, and the JETS ETF, was based firmly on the idea that the industry had changed, while the market hadn’t caught up to that fact. In other words, investors betting on the sector were betting that this time would be different.
The Pandemic Impact
Of course, “this time is different,” as the old saying goes, are the four most dangerous words in investing. And what the recent crisis has proven, unfortunately, is that this time is not different.
Airlines are wonderful businesses … when the economy is wonderful. When it’s not, they lose money in a hurry.
Indeed, amid the current grounding, U.S. airlines are losing billions of dollars a month. An industry group has estimated global revenue losses of as much as $113 billion. Even in a so-called “V-shaped” recovery, the hit could exceed $60 billion.
Again, it’s tempting to chalk all of those losses up solely to the current pandemic. But there are other factors at play.
For one, there were signs of a global economic slowdown before the coronavirus spread, signs that look more obvious in retrospect.
But, more importantly, a recession was going to arrive at some point. That’s simply how economic cycles work. And while it looked like airlines had done a decent job managing their debt, looking closer that clearly wasn’t — and isn’t — the case.
Saving for a Rainy Day
As airlines looked for a federal bailout, an analysis by Bloomberg made the rounds on Twitter. The industry had spent 96% of their free cash flow over the past decade on share repurchases.
I’m not an investor who believes share repurchases are inherently wrong. They’re simply a method of shareholder returns.
But for this industry, with its history of collapsing during a recession, executives should have been spending that cash on de-risking their businesses. Even before the pandemic, the U.S. economy was in the midst of its longest expansion ever. Last year’s “inverted yield curve” was a warning signal for a recession.
That’s one key risk that I frankly missed. The other is that I failed to see the extent to which airlines hadn’t prepared for a downturn. Relative to underlying earnings, debt had come down. But that was because of booming profits — not debt reduction.
In fact, debt on the United Airlines (NASDAQ:UAL) balance sheet increased over $3 billion between the end of 2016 and the end of last year. American Airlines (NASDAQ:AAL) still has far and away the highest figure, with long-term debt over $24 billion as of Dec. 31. It spent over $12 billion on buybacks in a little over five years.
Delta Air Lines (NYSE:DAL) has done a bit better, but not well enough. Only Southwest, as always, seems well-positioned, with a manageable balance sheet.
The Problem With the JETS ETF
And that leads to a significant problem going forward in believing that JETS is one of the best ETFs to play a market rebound.
The problem is that the ETF owns all of the U.S. airlines (as well as small stakes in overseas operators). And it’s difficult to argue that investors should own all of the U.S. airlines (though Buffett said earlier this month that he wasn’t selling his stake).
As I detailed last week, United in particular has a significant management problem. American’s CEO, Doug Parker, said in 2017 that “I don’t think we’re ever going to lose money again … We have an industry that’s going to be profitable in good and bad times.” That quote will live in infamy alongside that of former Citigroup (NYSE:C) CEO Charles Prince, who said just before the financial crisis, “As long as the music is playing, you’ve got to get up and dance.”
Citigroup, too, required a federal bailout. Prince left just months after his quote. Parker still holds his job.
I can see a long-term case for buying the dip here. But based on capital allocation alone, it’s much harder to recommend buying a basket of airline stocks. LUV stock has outperformed given its stronger balance sheet, and is the only airline that has created long-term shareholder value. A higher-risk case can be made for Delta stock as well.
But challenges remain for the sector. A near-term recession seems likely even once this nationwide self-quarantine comes to an end. International travel may stay depressed for years, with occasional closures as coronavirus epicenters flare worldwide.
There are stocks out there for bottom-timers. But some airline stocks clearly aren’t on that list. And too many of those names are in JETS to see it as one of the best ETFs going forward, even at half-price. Again, I got this wrong in December. I don’t want to double down on that mistake.
After spending time at a retail brokerage, Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets. As of this writing, he did not hold a position in any of the aforementioned securities.