In the past couple of weeks I’ve written a number of articles on out-of-favor stocks that appear in our Large Cap 1000 Screener (which you can access for free here). The latest out-of-favor industries are autos and airlines and the two stocks I wrote about in particular were Fiat Chrysler Automobiles NV (NYSE:FCAU) and Southwest Airlines Co (NYSE:LUV).
You can read the articles here:
- The One Automobile Stock That Value Investors Should Own Right Now
- Cashflow Beast : Southwest Airlines Co (LUV)
- Here’s Why Warren Buffett is Buying Airline Stocks
So it came as no surprise when I read the following recent article at Barron’s titled, Why Mohnish Pabrai Likes GM, Fiat, and Southwest Air where he discusses why he continues to invest in both of these out-of-favor industries today.
The article provides further confirmation that the stock picks provided here at The Acquirer’s Multiple are inline with the thinking of two of the best value investors on the planet, Mohnish Pabrai and Warren Buffett.
Here’s the Barron’s article:
Mohnish Pabrai is a concentrated value investor who has put together an impressive record since founding his firm, Pabrai Investment Funds, in 1999. A Wall Street outsider with a background in technology, Mumbai-born Pabrai set up his fund using the same fee structure as Warren Buffett’s partnership of the 1950s and ’60s (no fee based on asset size, but 25% of profits above a 6% return). Pabrai Funds returned 14.2% annually, after fees, since its inception in July 1999 through the end of 2015. That compares with a 4.3% average annual gain for the Standard & Poor’s 500 index.
Pabrai is the author of the investing book The Dhandho Investor, which explains his value-investing philosophy. He is also well known for paying $650,000, along with fellow value investor Guy Spier, to have lunch with Buffett in 2008.
“Through my entire investing career, I hated auto manufacturers, and I still hate them. In spite of hating them, I think autos are half the portfolio.“ — Mohnish Pabrai Thomas Michael Alleman for Barron’s
He recently spoke with Barron’s by phone from his offices in Irvine, Calif., and discussed why he has so many investments in two industries that he previously hated: autos and airlines. Here’s what he likes about General Motors (ticker: GM), Fiat Chrysler Automobiles (FCAU), and Southwest Airlines (LUV).
Barron’s: How did you become an investor?
Pabrai: Really by accident. My background is in technology. I’m an engineer. In the mid-90s I was running an IT services system-integration company and quite by accident heard of Warren Buffett for the first time—I think in 1994.
I read his biographies, and then I went to the Berkshire letters, and I was really stunned. I was an outsider looking into this industry, and a few things stood out for me. One of the things was that the way Warren Buffett invested was completely different from the way the mutual-fund industry invested. When I looked at the typical mutual fund with 150 stocks and 80% turnover, year after year, and when I looked at the way Buffett did things [creating concentrated portfolios with stocks that he held onto for years], the two were very different, and the results were way different.
I had about $1 million after I sold a portion of my business, and I really didn’t have any use for that money. So I said, you know what? I’m going to try to apply Buffett’s approach to investing to a portfolio and see how I do. I started to apply his approach, and it did extremely well.
It was an unusual period because the dot-com boom and bust took place and a lot of brick and mortar companies became severely undervalued. So I found from ’95 onward, through ’99, that I really enjoyed analyzing businesses, and I enjoyed it more than the company that I was running.
What kinds of companies do you look for? Do you look for wide-moat companies, or something else?
In the past 20 years, when I look back on it, most of my success hasn’t come from wide-moat investing. Typically, those businesses are rarely cheap enough to entice cheapskates like me. Most of my ideas have come from special situations or markets not understanding certain businesses and mispricing them. My ideas have usually come from anomaly-based investing.
Through my entire investing career, I hated auto manufacturers, and I still hate them. In spite of hating them, I think autos are half the portfolio.
What happened to GM and Chrysler when they went through bankruptcy reorganization, when the auto bailouts took place in 2009, is that they got rid of a lot of stuff. The health-care liabilities went away; all the debt went away. They were able to renegotiate their contracts with the [United Auto Workers union]. In 2007, Detroit was probably the worst place on the planet to manufacture a car, and by 2010, it was probably the best place on the planet to manufacture a car. The market didn’t understand that then, and probably doesn’t now. These businesses have been given up on as commoditized, unionized, high-capital-expenditure businesses. The market doesn’t appreciate that they have some attributes and assets that make them very compelling.
When I was buying Fiat in 2012, it was a company with more than $100 billion in sales, and a market capitalization of about $5 billion. So it was wildly mispriced then, and even today it is wildly mispriced. The business is misunderstood by the market.
GM has a market cap around $50 billion, and nearly $20 billion in cash. It trades for four times earnings. But the four times earnings has embedded in it a finance business that could generate $2 billion a year in cash flow by 2018. It should get a 15- or 20-times multiple since it isn’t a cyclical business. Then you have the GM auto parts business, which serves the aftermarket. That also has no cyclicality. The China business lacks cyclicality because it is growing. There is about $5 billion in cash flow coming from very stable businesses. They are worth $70 billion or $80 billion; yet, the whole company is worth about $50 billion, based on its current stock price.
Why do you own GM warrants, instead of the common stock?
The warrants date back to 2009, during the auto bailouts. They are unusual instruments that the company never would have issued if it were as healthy as it is today. It was forced to issue them. The warrants have a 10-year life and some unusual provisions. For example, I can put the warrants back to the company anytime and exchange them for shares. I don’t need to sell them into the market. That has a tax advantage for me.
The warrants are an option. If GM’s stock price doubles, I will make 3.5 times on the warrants.
What is the strike price on the warrants?
$18.33. [The current stock price is $36.]
What is GM’s stock worth?
GM has an exceptional leader [Mary Barra] and her goal is to make GM the most valuable car company on the planet, which would triple or quadruple its market cap. I don’t know that it will go there. But a double in GM for a business that is cranking out all these cash flows and has leadership positions isn’t out of the question. GM in the mid-to-high $60s in a couple of years is reasonable. It is really cheap now. The dividend yield is 4.4%.
How about Fiat?
Fiat has guided for $4.50 a share in earnings in 2018. The stock is about $8 and that’s a price/earnings multiple of 2. What do I think the company is worth? At some point probably in the 2018 to 2020 timeframe the company is going to sell itself. It will be very surprising to me to find Fiat not trading for at least $20 a share by 2018. If they do a deal, it would be north of $30.
They have a parts business that is on track to produce $500 million in cash flow. That business is probably worth more than $5 billion, or something like 50% of their market cap. Fiat has an exceptional management that has taken steps, like spinning out Ferrari [RACE], to unlock value that wasn’t visible to the market. They’ll probably sell or spin off the parts business. If at some point they do something with Maserati or Jeep, the valuation goes above $20 to $30 a share.
Sergio Marchionne, the CEO of Fiat, has said in the past that he would like to merge with GM.
He still would, but GM has said it isn’t interested. Fiat ran the numbers internally. They showed that if you take the $160 billion a year that GM sells and the $120 billion a year that Fiat sells, and you merge into a $280 billion company, you would take out at least 3% or 4% in cost. That’s about $10 billion, not much less than the entire market cap for Fiat.
The reason Fiat wanted to do the merger is that, even if Fiat captured 30% of those synergies and GM captured 70%, it would be a massive home run. My guess is that Fiat management will do some deal in the next two to three years. Whether it is with GM or maybe by then Volkswagen [VOW.Germany], we will have to see.
One pushback on autos is that in North America, we are at peak levels in the cycle.
There is some misunderstanding about peak autos. All three of the big auto manufacturers [ Ford Motor (F) is No. 2], have said that it’s not so much peak, but that sales will stay at this level for a while. The reason for that is that every year the population of this country increases by three million, or 1%. Since 2007, we added almost 30 million people.
Most analysts don’t population-adjust when they look at past auto numbers. Second, we still haven’t recovered all the lost volume in autos from 2009 onward. The U.S. auto fleet is the oldest it has ever been. The average car is 11.5 years old. The average truck is about the same. One of the reasons we have an old fleet is because incomes have stagnated. It’s the same reason why the housing market hasn’t come back.
Autos aren’t a luxury item; they are a mandatory item. If you want to go to work, you need an automobile. The industry has gone through so many cycles in the past that analysts just feel that the moment we get to peak autos, and the cycle dies, these companies will start burning cash. What has actually happened is, there has been a lot of discipline that has come into the industry. All three managements don’t pursue market share; they pursue profits.
U.S. auto sales were over 17 million last year, and they will be over 17 million this year. I would be shocked if they were under 17 million next year, especially when you consider all the construction that [President-elect] Trump wants to do.
Airlines are another hated industry.
I feel really good that I bought Southwest at the same time as Buffett. [ Berkshire Hathaway (BRK.A) recently bought shares of the big four airlines. Pabrai Funds also added Southwest Airlines in the third quarter.] I actually bought it before Berkshire because their purchase was in the fourth quarter.
So why did Berkshire buy into this really crappy industry? I believe they think the industry has changed, just as the auto industry has changed. I don’t know if you’ve been on a flight lately, but there are no empty seats. The load factors are through the roof. We aren’t going to see high oil prices, pretty much ever, because if oil goes to $60 a barrel, they will start pumping in West Texas. The fracking companies can be profitable in some parts of Texas at $35-a-barrel oil. So oil, for any sustained period, isn’t going to go up.
Airlines benefit because of the costs. They have huge load factors, very cheap fuel, and most of the competitors are gone. There is also a monopolistic aspect to these businesses depending on where a customer lives. If you live in Dallas/Fort Worth, you will fly American, and if you are in Newark, N.J., you will fly United, because they dominate there. The airlines aren’t exactly commodities because in certain parts of the country, different ones dominate. The dominant ones in that place have pricing power.
There are elements of the business that are good. But they were overshadowed by the bad. Fuel is volatile; labor relations were volatile. And they had too many competitors. Now, from a dozen airlines or more, they are down to four or five.
Why did you choose Southwest over the other airlines?
I like their culture the most. They are all cheap, but Southwest has the best culture. I think it was The Wall Street Journal that did an article on Delta Air Lines [DAL], United Continental Holdings [UAL], and American Airlines Group [AAL], showing that cabin interiors for all three are now the same. They’re all shades of gray and blue. So these three are becoming clones of each other.
Southwest is its own animal. It’s doing its own thing. It is also very cheap. I was buying it in the mid-$30s. [The stock was recently $49.60.] I bought it at six times earnings. People think these earnings are cyclical, but I don’t think they are cyclical.
What is a reasonable valuation?
Airline stocks are going to double or triple in the next few years. It will be driven mainly by multiple expansion. Southwest is going to start flying to Hawaii, and I’m almost sure they are going to start flying to Europe. When Southwest switches its model to flying four-hour flights instead of one-hour flights, the economics are going to get a lot better. They have a lot of room to grow.
Mohnish, thank you for your time.
To read the full article at Barron’s, you can find it here.
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