For many new to the share market, the country’s flagship airline is likely one of the first companies that spring to mind as a potential investment (along with a major bank, supermarket and, in Australia, perhaps a big miner). The majority of people have some experience travelling on a plane, they may have an opinion about the quality of the airline’s service versus competitors, and the idea of owning part of the “spirit of Australia” might have some romantic appeal–similar to the notion of flying itself. With Qantas (ASX: QAN) posting record profitability in its August results release and its shares falling more than 20% from their recent highs, many will be asking if this is the time to buy the dip.

Qantas cannot seem to keep out of the headlines, with almost every week seeming to bring on a new story. The company has hit the press for concerns about baggage handling, the pay of former CEO Alan Joyce (and his recent property purchases), the rising cost of ticket prices, illegally sacking 1,700 workers, allegations of illegally marketing cancelled flights, and now just this week, both shareholders and pilots are demanding chair Richard Goyder resign.

While Mr. Goyder maintained that he had the confidence of the Qantas board and major investors just last week, Australian and International Pilots Association president Tony Lucas said the morale of Qantas pilots has never been lower and new CEO Vanessa Hudson issued an apology for the airline’s recent performance. This follows an even more turbulent period during the pandemic when the airline received heavy criticism for its lack of repatriation flights while benefiting from an extraordinary level of financial support (that many other businesses, including rivals Virgin Australia and Rex did not receive).

Often such overwhelmingly negative headlines can lead to interesting investment opportunities. They are a particular favourite of so-called “contrarian investors”, who are a type of value investor that specifically target this type of scenario. Similar to traditional value investors, contrarian investors use a fundamental approach to valuing shares (that is, they look at the company’s financial metrics such as its balance sheet and cash flows, rather than using momentum or other technical analysis to direct their trading strategies).

The key difference though, is that contrarians add a psychological element to the investing process. They look specifically for companies that are out-of-favour with the media and/or the investment community because of issues that they believe are more temporary in nature (according to their investment horizons, which might range from several months to several years).

Their belief is that the negativity is exaggerated or overblown, and that over time the share price will recover as the company continues to deliver a high level of profitability–leading to greater dividends for shareholders. In effect, contrarian investors are betting that the current pessimism is more superficial than tangible to the company’s actual financial results. Could this be the case for Qantas today?

As a longer-term investment, an airline lacks many of the criteria of a quality company. The strongest evidence of this is in the company’s profit margins and return on equity, which fluctuate quite dramatically from year to year (companies that are better able to control their environment, including changes in costs and revenues, are more likely to have more stable margins and return profiles).

Given enough thought, most people would understand this intuitively when considering how difficult it is to actually run an airline. They often have competitors that are partially owned by governments willing to run them less profitable than other private businesses (such as Singapore Airlines and Emirates); demanding, price-sensitive customers that can complain to politicians (as we are currently witnessing); a high-cost and usually unionised workforce; must pay the ever-increasing fees of the major airports; and are subject to a number of major challenges to their operations and reputation–be it missing planes (Malaysian Airlines MH370), terrorism (Malaysian Airlines MH17, September 11), technical faults (Air France Flight 447, technical faults (Boeing 737 Max), and of course, viral outbreaks.

Even greater than these more obvious factors though, is the operating leverage in the business. Operating leverage refers to the increase (or decrease) in profits that come from an increase (or decrease) in sales. A company with a high degree of operating leverage usually has a large amount of fixed (rather than variable) costs. This includes things like buildings, infrastructure, vehicles and the like. An airline spends a huge amount of money on planes and other fixed costs, and the plane will typically fly whether it is full or not, and whether the customers have paid a lot or a little for their tickets. Similar to a hotel, an airline’s profitability will fluctuate significantly depending on the level of occupancy (how full the plane is) and the price that the customers have paid for their tickets.

The other major fixed cost is fuel. The amount of fuel an airline uses doesn’t vary much from year to year (assuming the same number of flights), but the price of oil (which determines the price of fuel) can move a lot. In just the last 12 months alone, the price of West Texas Intermediate (one of the two major oil prices, along with Brent) has fluctuated between $63.64 and $93.74–nearly 50%! With very little ability to manage this expense, an airline has no real option other than to increase prices–which may lead to a significant decline in demand, particularly on less popular routes.

Starting in 2016, chairman and CEO Warren Buffett began building stakes for Berkshire Hathaway (NYSE: BRK.B) in the four major U.S. airlines [Delta Air Lines (NYSE: DAL), Southwest Airlines (NYSE: LUV), American Airlines Group (NASDAQ: AAL), and United Airlines Holdings (NASDAQ: UAL). By early 2020, these had become sizable investments worth more than US$4 billion, with Berkshire’s investments in a couple reaching 10% ownership. Speculation was building that Berkshire may even buy an entire airline outright.

Buffett’s investment thesis was that the industry had consolidated to the point where competition had become much more rational–similar to the railroad industry, where he had successfully purchased BNSF back in 2009.

Yet the government restrictions early in the pandemic were a crippling blow, and Buffett exited all of the airlines in April 2020. There was an incredible amount of uncertainty at the time–particularly on whether the government would provide a sufficient bailout, the likely level of future business travel, and the level of debt the airlines would need to take on to survive.

Interestingly, despite the rebound in travel volumes, the share prices of the four airlines have continued to struggle, each down more than 40% from their all-time highs, and American Airlines and Southwest Airlines are in fact similar prices to when Buffett sold.

The deluge of negative headlines for Qantas at a time when the company is generating record profits might spark the contrarian in you, and this is certainly not a bad way to uncover potential investments. Some of the great investors have made their fortunes betting against the herd, including Buffett’s famous investment in American Express following the company’s notorious “Salad Oil Scandal.”

Airlines, however, are a very tough business – even for one such as Qantas that dominates some of the most profitable routes in the world. While the pandemic may seem like an anomaly, the company’s long-term financial and share price performance have not richly rewarded shareholders. Instead, a true contrarian might revisit the company when profitability is under pressure and set to improve. For us, we will continue to watch from the sidelines.