This article is a part of InvestorPlace.com’s Best ETFs for 2020 contest. Vince Martin’s pick for the contest is the U.S. Global Jets ETF (NYSEARCA:JETS).
My pick for the best exchange-traded fund of 2020, the U.S. Global Jets ETF (NYSEARCA:JETS), turned out to be an exceedingly poor choice. JETS has lost nearly half of its value so far this year. A sharp rally last month offered some hope that it could stick among the best ETFs to buy this year, but those gains have reversed over the last three weeks.
It’s easy to chalk up the miss to the novel coronavirus pandemic. (I can also take solace in the fact that my 2019 pick, the iShares U.S. Home Construction ETF (BATS:ITB), rose a sterling 48%.) But as I wrote at the end of March, the pandemic simply exposed significant weaknesses in the U.S. airline industry, in particular. And I missed the most important of those weaknesses.
Put simply, airline executives got overconfident. American Airlines (NASDAQ:AAL) chief executive officer Doug Parker infamously said in 2017 that “I don’t think we’re ever going to lose money again.” The rest of the industry agreed. As a result, as Bloomberg detailed this year, over a decade the five biggest U.S. airlines (including American) “spent 96% of their free cash flow on share repurchases.”
That cash needed to go to debt reduction to limit the industry’s exposure to a recession. It’s true that no one predicted the arrival of the coronavirus. But the risk of a pandemic was known — and detailed in airlines’ filings with the U.S. Securities and Exchange Commission. That aside, a recession was going to arrive at some point.
Airlines needed to prepare. They didn’t.
That problem still holds. And now, with the coronavirus case count rising, the industry is facing renewed short-term challenges as well. As a result, with JETS back where it traded in late March, I’m nowhere close to returning to my past bullishness.
JETS Is No Longer One of the Best ETFs
It’s tempting to argue that airline stocks in general, and the JETS ETF in particular, are “too cheap.” Again, the ETF is down by nearly half. American, United Airlines (NASDAQ:UAL), and Delta Air Lines (NYSE:DAL) have performed even worse.
Meanwhile, federal assistance seems to take near-term bankruptcy risk off the table. And, at some point, normalcy should return.
But that analysis misses a key problem: leverage. And airlines are significantly leveraged in two key ways.
The first is on the balance sheet. The U.S. airlines alone have tens of billions of dollars in debt between them. The figure is only going to rise as the industry burns cash in 2020 (and potentially 2021 as well). Every dollar in lost value of the business has a magnified impact on the value of the equity.
That impact is then amplified still further by the business model. Lost revenues have a huge impact on operating profit. Incremental revenues are hugely profitable: it’s really the last few passengers that makes a flight profitable at all. That is a key reason why the industry has such a checkered history: Southwest Airlines (NYSE:LUV) is the only major U.S. carrier to have avoided bankruptcy.
The leverage problem simply makes it exceedingly difficult to argue that the sector is “too cheap.” The industry’s history shows it can get cheaper.
A Second Wave
Meanwhile, JETS is heading in the wrong direction after a steep rally.
Indeed, the ETF saw a massive influx in assets, which rose nearly 3,000% in three months. Traders at Robinhood appear to have been a key driver.
But the number of Robinhood traders holding the fund has stalled out (pardon the pun). And the rest of the market seems to be selling. It’s not hard to see why.
A so-called “second wave” of coronavirus cases is hitting states like Texas and Florida. Europe is reportedly considering banning U.S. travelers over coronavirus fears. That would remove profitable international flights from already-thin airline schedules.
Again, airlines are already burning billions of dollars in cash. Short-term losses now look potentially higher. That has a real impact on fundamental fair value for airline stocks.
But it also presents a short-term impact to investor sentiment. Value investors were interested in the fund last month, when it looked like normalcy might be getting closer. If those hopes are dashed, so too are any hopes for a rally in JETS.
Vince Martin has covered the financial industry for close to a deacde for InvestorPlace.com and other outlets. He has no positions in any securities mentioned.