When growth becomes value

Value investing is sometimes presented as the opposite of growth investing. While the latter looks for innovative, high growth companies, the former seeks out grubby, often low quality and low growth companies that are cheap because no one wants them. This is a crude distinction at best. And whilst it may apply to some forms of value investing, it is not reflective of the way we approach it.

Growth is a vitally important component of our investment approach. Winning business models in growing industries are attractive to us for two reasons. Firstly, they are more likely to create shareholder value over the long term by harnessing the growth opportunities in their own industries, as opposed to mature businesses that try to expand into new areas, with all the risks that this entails. Secondly, the stock market typically – and usually correctly – pays a premium for growth businesses. This means there can be substantial share price upside when such companies can be purchased at knock down valuations.

One area we often find such opportunities in is industries that exhibit a high degree of short term volatility, where prevailing market narratives can rapidly shift from optimism to despair, often in response to short term, cyclical or temporary factors. Not only can this cause share prices to be a lot more volatile than warranted by the underlying long term fundamentals, it can also result in opportunities to invest in long term winners due to the whole industry being out of favour with investors.

We believe the travel industry may be exhibiting these characteristics today.

It’s been a bumpy ride…

When thinking about the travel industry as an investment proposition, there is an understandable tendency to anchor on all the things that can and have negatively impacted it over the years – wars, natural disasters, terrorist attacks, not to mention pandemics. Yet despite this, the industry churned out 4.6% annual growth in the three decades leading up to 2020, with relatively little long term impact from most of these exogenous shocks.

The impact of the pandemic was of an order of magnitude greater for obvious reasons. But as of 2023, passenger volumes were almost back to 2019 levels, according to IATA1. And it is widely expected that the longer term growth trajectory will continue, as incomes and wealth continue to rise leading more and more people to hit the skies.

Sources: HSBC research. 1980 – 2020: International Energy Agency (https://www.iea.org/data-and-statistics/charts/world-air-passenger-traffic-evolution-1980-2020). 2020 – 2023: Statista and IATA estimates.

…that has not benefited everyone

Business models within the travel industry come in all sorts of shapes and sizes. And not all of them have created shareholder value.

Warren Buffett famously quipped that investors would have saved billions of dollars if someone had shot down the Wright brothers’ plane on its maiden flight. Despite huge growth in passenger numbers, the airline industry in aggregate has destroyed shareholder value as a lack of pricing power and subsidised national flag carriers have continually depressed profitability.

But what may be true in aggregate does not necessarily apply to every company.
We find many examples of business models in the travel sector that we believe have created shareholder value over the long term. They typically combine a scale advantage in one or more areas with a low cost operating model. Here are three UK listed companies currently held in the funds that we believe exhibit these characteristics.

Jet2: vertical integration at scale

The Jet2 business model combines a low cost airline with a package tour operator. Vertical integration like this means less price sensitive package holiday customers can fill up the capacity on the aircraft, so there is less need to price aggressively for the airline only customers. The scale advantage stems from the company’s local dominance in certain airports and on specific routes, allowing it to offer a great service whilst still being competitive on price. This has been a winning business model in recent years, as Jet2 has continually taken market share to become the largest tour operator in the UK.

Wizz Air: lowest cost operator

Wizz Air is the only European short haul airline that can match Ryanair on costs. Whereas Ryanair built up its scale and cost advantage in western European markets, Wizz Air has done it in eastern Europe. In an industry where there is little differentiation and where consumers are primarily driven by price, having the lowest costs is the only viable path to long term outperformance. By continually driving down costs, air fares can be priced below less efficient competitors, driving more market share gains. In these models, scale begets more scale, as bargaining power improves with key suppliers such as aircraft manufacturers, airports and advertisers. There can be a lot of year to year volatility in profits due to a multitude of exogenous factors (consumer confidence, fuel prices etc), but over the long term the growth potential is huge, as Ryanair has demonstrated.

SSP: food service at scale

SSP is a food service concession operator, specialising in airports and train stations. Unlike single brand high street restaurant chains, where it is very difficult to differentiate, SSP brings a portfolio of brands, both in-house and franchised. The marketplace is less competitive than the high street and there is an element of customer captivity as customers are waiting in a specific area to catch a plane or train. SSP is one of the only outsourcers that operates all around the world with big global brands such as Starbucks amongst the brands it can offer. This gives it a competitive advantage when bidding for new contracts against smaller local competitors.

Short term pain for long term gain?

Considering these attractive attributes, it is surprising to us that the stock market is valuing these businesses considerably lower than it was in 2019 (see tables below). For sure the pandemic was an extremely challenging period and perhaps this experience is still fresh in investors’ minds.

But a plausible argument could be made that these business models are actually in a stronger position today than they were in 2019. All have invested counter cyclically. Jet2 and Wizz Air placed large aircraft orders at the low point in the cycle underpinning their growth for years to come, whilst competitors have retrenched. Both Jet2 and SSP raised equity to protect their businesses, with the latter investing heavily in growth capex and opportunistic acquisitions that should drive growth well into the future. Meanwhile competitors have fallen by the wayside, with the result that market share for these businesses is far higher than they were in 2019.

Travel companies – pre versus post pandemic

Source: Bloomberg as at 11.10.2024

So what might explain this apparent valuation anomaly? As is so often the case with this sector, we believe it is primarily due to a shift in short term investor sentiment, which is currently depressed.

There was an expectation at the start of 2024 that this would be another year of strong airline pricing, as the strong recovery from the pandemic continued. Ryanair in particular had guided to this effect, but has since had to row back as consumers have been booking later and behaving in a more price conscious manner, although others such as Jet2 had lower expectations to begin with and have not changed their guidance. In any case, this has created a lot of nervousness and uncertainty in the short term.

We do not claim to have any special insight into how the remainder of 2024 will play out, except to point out that this has always been a volatile industry with limited visibility in the short term. Instead, we prefer to focus on the prize that awaits those businesses that are able to capitalise on the long term growth opportunities available to them.