The Industry That Buffett Got Wrong

As 2017 rushes forward, I'm seeing confirmation of my market outlook from the beginning of this year. In the past week, it's become clear that Warren Buffett now agrees with my assessment of airline stocks. I'll admit I was nervous as I dove into the sector against Buffett's advice. But his opinion changed, as I thought it would.

Last week, I recommended a familiar trade to subscribers of my premium newsletter, Income Trader. The trade involves United Continental Holdings (NYSE: UAL), the holding company that owns and operates United Airlines. And the trade this week looks poised to join the seven successful trades we've made on the airline in the past.

United Airlines operates more than 4,500 flights per day, reaching more than 300 airports and more destinations than any other airline. In 2016, United and its subsidiary, United Express, served more than 143 million customers on 1.6 million flights.

United operates more than 730 aircraft, and this year, the airline anticipates taking delivery of 19 new Boeing aircraft and six used Airbus A319 aircraft.

Among the company's shareholders are Warren Buffett, who has now invested more than $2 billion in UAL and has a total of about $8 billion in the industry, including stakes in American, Delta (NYSE: DAL) and Southwest Airlines (NYSE: LUV). We don't know what exactly changed Buffett's mind, but his partner, Charlie Munger, recently offered some insights.

The 93-year old Munger admitted that both he and Buffett gained wisdom gradually, noting, "Warren learned better over time, I've learned better. The nice thing about the game we're in is you can keep learning, and we're still doing it."

Munger added that the two of them used to think airlines were such a terrible business they were "a joke," the same opinion they once shared about railroads. But, their minds changed on both railroads and airlines.

Munger explained, "We did the same thing with railroads -- 'railroads are no damn good, too many of them, truck competition.' We were right -- it was a terrible business for about 80 years. Finally, they got down to four big railroads, and it's a better business. Something similar is happening in the airline business."

An Airline Industry Turnaround is Imminent

In part, Buffett and Munger have been forced to change as the investment industry changed. Munger said it was easier in the old days than now. Airlines are a sector where he believes they found a small edge. While there's not a lot of detail there, I believe Buffett and Munger saw what I noticed last year. Industry executives are behaving rationally. They are no longer competing with price wars and changing their fleet sizes in response to the business cycle. In the past few years, many of the differences between the major airlines have largely disappeared from passengers' perspective.

The frequent-flyer programs are all based on revenue where passengers are rewarded for spending more rather than flying on low-priced tickets. Fare classes, seat sizes and fees are almost exactly the same among different airlines. Companies are all following disciplined investment strategies, buying new planes and upgrading facilities on a schedule rather than spending more in good times and reining in operations in bad times. As a result, the airlines appear to be reliable investment opportunities.

UAL is working to increase earnings by cutting expenses, a strategy that should help the company when the economy and the airline industry suffer their next inevitable downturn. By 2020, UAL plans to reduce costs by $4.8 billion -- that's more than 12% of the company's 2015 revenue. A cost reduction of that size should allow the company to remain profitable in a normal recession and possibly even a major economic downturn.

Analysts expect the company to report earnings per share (EPS) of about $6.76 next year, and estimates have been increasing over the past three months -- a bullish indicator for the stock. At current prices, UAL is priced at about 9 times next year's estimated earnings. But if we value UAL at 14.7 times earnings -- the industry's long-term average -- the stock would trade at about $99 -- more than 30% higher from recent prices. This should be a conservative estimate of the stock's fair value because the industry turnaround is likely to result in a higher average price-to-earnings (P/E) ratio.

While simply buying the stock would be a good move, there's a better option. It's a strategy I use frequently and the same type of trade that I regularly recommend to Income Trader readers. And it allows you to generate income and have a shot at buying UAL at a discount.

In other words, you can in effect get paid for the chance to buy stocks at a discount. This is done using a conservative strategy that involves selling put option contracts.

Use This Simple Strategy for Big Gains

While the very mention of options can be intimidating to some investors, this strategy is actually rather simple. I won't get too much into the details here today, but assuming UAL trades for $70 or more on March 17, my Income Trader readers and I could make a quick 3.2% gain in 22 days.

If we can repeat a similar trade every 22 days, then we'd earn about 53% on our capital in 12 months. (This is exactly what we've done. Remember earlier when I said we've successfully traded UAL seven times already.)

Worst case, if UAL falls below $70, you'd likely be "put" the stock, i.e., the buyer of the put requires us to purchase the stock. But in this case, we'd effectively be buying the stock at a discount. We could then hold the shares until the turnaround occurs and our discounted shares become much more valuable.

What's great about this strategy is that you get paid to set the terms. You decide what you'd be comfortable paying for a stock should it fall to the specified price. And you set the timeframe that you're willing to wait. It lowers your cost basis if the stock falls to your strike price, and if it doesn't, then you simply keep the premium as pure profit.

What's more, you can repeat this process again and again -- and scale it up depending on your comfort level. As I've said before, selling puts is about as close as it gets to a win-win in investing. Since I launched Income Trader in 2013, I've managed to post an astonishing 134 winning trades out of 140. That's a win rate of 96%.

If you're not familiar with options, but this sounds intriguing to you, then I have a special presentation that goes into more detail about my strategy. And if you choose give Income Trader a risk-free trial, you'll also get a full slate of reports to quickly get you up to speed on options trading. To get started, go here now.

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