Opportunity Cost
Being right is good. Being right within the right timeframe is great.
In today's article, I'm going to step away from the usual style of company analysis to discuss a fundamental part of portfolio management: specifically, the timing of selling positions that are below expected performance.
The position used as a case study for this article is International Consolidated Airlines (IAG), an airline that includes British Airways, Iberia, Aer Lingus, and Vueling.
A bit of context about the thesis with which I opened this position:
In 2020, due to the pandemic, airlines dropped by about 50%, especially European ones, as the US has a strong domestic market that wasn't as restricted as international flights. The S&P 500 fell by approximately half, a figure that reflects the magnitude of the impact on the sector. The thesis was clear: International travel would eventually reactivate, and these companies would regain their demand.
Among the European airlines, IAG offered the best potential. I liked that it was able to recapitalize without resorting to public bailouts (unlike Air France or TAP) and offered a greater margin of safety than Lufthansa or Ryanair.
I usually require investment theses to have at least an 80% margin of safety, meaning the target price (or fair value) of the investment provides a potential return of 80% compared to the trading price. In the case of IAG, it was 100% (2.3-2.5 € per share) when the company was increasing capital at 0.90 per share + preemptive right (approximately 1.20 euros).
The fundamental thesis has been fulfilled: The financial debt caused by the pandemic has been overcome, flights have recovered, and the pandemic has led to improved operational efficiency and therefore better margins.
However, the stock price remains below pre-pandemic levels despite having recovered EPS and the good outlook for tourism in 2024. The following chart clearly shows the evolution of the price (blue series) versus LTM EPS and NTM EPS (recent past and expectations).
Among the main reasons are the absence of a dividend, which has been suspended since the pandemic, disaffection with the sector, the anticipation of the lower part of the economic cycle that drags down expectations for tourism in the coming years, and the costs of renewing the fleet to make it more sustainable.
The following graph shows how IRR of a potential return of 100% changes over years invested. As we could see, no matter how right we are if the market don´t recognice it in a reasonable time, the return of being right could underperform the easy and confortable life of indexation investment.
After 4 years, it is difficult not to be biased by the sunk cost fallacy and anchoring bias, waiting to reach the target price, but one must consider the opportunity cost of waiting.
Given that IAG is a turnaround within a sector highly exposed to the economic cycle, it is not the type of asset I want to hold from 2025 onwards. Being in a low part of the cycle, it could take 2 - 5 years to realize the Fair Value, and judging by the IRR graph, that could result in a poor investment.
Every investment thesis needs capital inflow and consensus to be realized. This is where the opinion of analysts who were shouting SELL when you bought becomes important. For your thesis to come true, you need capital to flow in, and there are millions that move to the tune of signals from analyst firms. In the words of a highly recommended Spanish Value manager:
"Whether we like it or not, the behavior of a stock or a market depends on the money flows from the investor community. Sentiment plays a fundamental role in this equation."
Javier Ruiz, Letters to Co-Investors from Horos Funds (Q4-2023)
Howard Marks caricatures the market as a pendulum, swinging from extreme fear when investors sell in panic to extreme greed, when incoming capital at any price seems endless.
This infographic reflects the pendulum for IAG. It shows the Fair Value of my thesis, €2.40 per share, the current price around €2.00 and analysts' estimates. Catalysts are factors that could drive the valuation in the short term, and limiters are part of the market narrative that could prevent it.
The conclusion through the two tools, the IRR curve and the pendulum, is clear: the opportunity cost of waiting indefinitely for the realization of the value is higher than the remaining margin, and the option that provides the greatest security is to close the position between the presentation of Q2 and Q3 2024 given the positive preliminary results in tourism.
The analysis of momentum through the two tools is an element I regularly use, and I hope it serves the reader as a point of reflection. That said, I must emphasize the characteristic that makes IAG a good candidate for this type of analysis at this moment: it is a turnaround within a cyclical sector.
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