August 2012. Josh was smiling broadly as he entered my office and said: “I have an idea that you will have a hard time liking. In fact, you will hate it. You might end up throwing me out of your office—forever. My idea is an airline. It is Southwest Airlines.”

Josh was correct. I knew that the airlines were a terrible business. Among the worst. When an airplane flies from one city to another, the labor, fuel, and other costs of operating the plane are almost the same whether the plane is 100 percent filled with paying passengers, or 50 percent filled, or empty. Therefore, airlines have particularly large financial incentives to fill as many seats as possible. Because many passengers will choose a flight solely based on the price of the ticket, airlines historically try to fill seats by offering the lowest prices. The result has been severe price competition between airlines—in fact, destructive price competition. So destructive that the aggregate profits of the airline industry since the days of the Wright Brothers have been almost nonexistent.

Furthermore, the airline business is highly capital intensive because airplanes are expensive to purchase or lease. With low or no profits, most airlines have needed to borrow heavily to purchase aircraft, and thus most have balance sheets that are highly leveraged with debt or lease obligations.

During periods of weakness, many airlines have been unable to service their high debt loads or lease obligations and have been forced into bankruptcy, and many have simply disappeared, including Pan Am (1927–1991), TWA (1925–2001), Eastern (1926–1991), and Braniff (1928–1982). According to Wikipedia, between 1979 and 2011, fifty-two U.S. airlines filed for bankruptcy. Amazing! As Warren Buffett wrote in his 2007 annual report to Berkshire Hathaway shareholders: “Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”

The years 2001 through 2011 were particularly miserable for the airline industry. The sharp drop in travel after 9/11 was followed by a sharp increase in fuel costs and then by another sharp drop in travel during the 2008–2010 recession. Most of the large U.S. airlines incurred sizable losses in the 2000s and struggled to survive. United Airlines declared bankruptcy in 2002, Delta and Northwest in 2005, American in 2011.

Josh believed that the miserable conditions in the 2000s would trigger a period of prosperity for the airlines. Here’s why. Airlines suffering large losses do not have the financial incentives or financial wherewithal to purchase many new airplanes. If fact, they have incentives to reduce costs by selling their less efficient planes. And that is exactly what happened between the years 2000 and 2011, with the result that the effective capacity of the domestic airlines declined by 3.1 percent from 701.5 billion seat-miles to 679.5 billion seat-miles. And during the same 11-year period that capacity declined by 3.1 percent, the demand for domestic air travel, largely driven by population growth, increased by 12.4 percent from 502.3 billion seat-miles to 564.7 billion. As a result, whereas the average flight in 2000 operated at 71.6 percent capacity, the average flight in 2011 operated at 83.1 percent of capacity.

Because most flights that depart at unpopular hours or that fly to less popular locations do so with many empty seats, if the entire airline industry operates at 83.1 percent of capacity, then many of the more popular flights will operate at full capacity—and many with wait lists.

Josh’s thesis was that capacity would continue to tighten because relatively few new airplanes were on order by the domestic carriers. He believed that, as capacity tightened further, the domestic carriers would be able to increase their prices and that the increased prices would lead to much higher profits and much higher share prices for the airlines.

At the time Josh entered my office, Southwest Airlines’ shares were selling at only a touch above their book value of $8.34. Unlike almost any other domestic airline, Southwest had been continuously profitable for decades and had as much cash as debt. The company had earned an excellent reputation as a well-managed and highly reliable low-cost carrier. Amazingly, Southwest was the fourth most admired company in the whole world, according to Fortune magazine’s 2011 survey. Southwest was ahead of Procter & Gamble (the fifth most admired company), Coca-Cola (#6), Amazon (#7), FedEx (#8), and Microsoft (#9). The only other airline that made Fortune’s top 50 list was Singapore Airlines at #18.

Southwest Airlines was incorporated by Herb Kelleher and Rollin King on March 15, 1967, as Air Southwest Company. The initial plan was to fly only between three major cities in Texas: Dallas, Houston, and San Antonio. Kelleher, who was the leader of the two founders, believed that by being an intrastate carrier within Texas, Air Southwest could avoid burdensome federal regulations. However, litigation delayed the start-up of the new airline when Braniff, Continental Airlines, and Trans-Texas sued to block the addition of a new competitor. The suit labored in the Texas courts for more than two years, but in late 1970, the Texas Supreme Court upheld Air Southwest’s rights to form a regional airline. In March 1971, Air Southwest changed its name to Southwest Airlines, and three months later the brand new airline commenced service between Dallas, Houston, and San Antonio with three (soon four) Boeing 737s.

From inception, Herb Kelleher decided to model Southwest after Pacific Southwest Airlines, a California-based regional carrier that was founded in 1949. Pacific Southwest was the first major carrier to offer discount fares. In addition, it attempted to attract customers by making flying fun. Flight attendants and pilots were encouraged to joke with passengers. In the 1960s, the flight attendants’ uniforms included miniskirts—and in the 1970s, when fashions changed, hot pants. The company painted a smile on the nose of each of its planes. Keeping with the desired ethos of the company, Pacific Southwest’s founder, Ken Friedkin, wore brightly colored Hawaiian shirts. Pacific Southwest’s slogan was “The World’s Friendliest Airline,” and the friendliness worked and attracted paying customers.

While potential competitors normally are not friendly to each other, Ken Friedkin seemed flattered that Herb Kelleher was interested in copying Pacific Southwest’s business model and generously agreed to help train some of Southwest’s repair mechanics and to offer Southwest flight, operating, and training manuals.

Kelleher selected Love Field in Dallas for the company’s headquarters and adopted the word “love” as the company’s motto for early advertisements. Beverages served to passengers were known as “love potions” and peanuts as “love bites.” The company stock ticker symbol on the New York Stock Exchange was LUV. A committee formed to select flight attendants included an individual who had selected the attendants for Hugh Hefner’s Playboy airplane. The flight attendants selected by the committee were described as cheerleaders, majorettes, or long-legged dancers with outgoing personalities. Herb Kelleher dressed them in hot pants and go-go boots. Clearly, Southwest was closely following Pacific Southwest’s offbeat, fun, and successful model.

It is difficult to start up a new airline. Passengers usually feel safer flying with an established carrier that has a track record for reliability and safety. Southwest had difficulty attracting passengers in 1971 and 1972 and was unprofitable—so unprofitable that the company had to sell one of its four 737s to meet its payroll and other expenses. To compensate for the loss of 25 percent of its capacity, Southwest found ways to substantially reduce the time each remaining airplane remained on the ground between flights. This was the start of a concerted effort by Kelleher to model Southwest into a highly efficient, very low-cost carrier.

With low costs, low ticket prices, and a “love” business model, Southwest started to become successful by the mid-1970s. Its revenues in 1975 grew to $23 million, up from $15 million in 1974 and $9 million in 1973. The company about broke even in 1973, was in the black in 1974, and earned $3.4 million after taxes in 1975. The profitability permitted Southwest to purchase additional aircraft. By 1978, the company operated 13 Boeing 737s that serviced 11 Texas cities. Revenues and after-tax profits in 1978 were $81 and $17 million. Southwest Airlines was on the map.

In 1978, the airline industry became largely deregulated, and Southwest decided to expand outside of Texas. Its first interstate flight was from Houston to New Orleans on January 25, 1979. During the next two years, buoyed by the success of its low-cost, low-fare strategy, Southwest continued gradually to expand its service to additional cities. By 1980, the company was servicing 14 cities. Its revenues and after-tax profits in 1980 increased to $213 million and $29 million. In its 1980 annual report, management stated that the company’s “unique combination of low fares, frequent service on short-haul routes, exemplary employee productivity, and high utilization of its assets” had saved its passengers substantial sums of money and, at the same time, had “achieved the highest operating profit margin of any domestic air carrier and had achieved, over the past five years, an annual return on stockholder equity of 37%.”

During the next 20 years, Southwest continued to grow rapidly, partially due to the expansion of its network to most major cities in the United States, partially due to its low costs and fares, and partially due to its innovation and good management. Between 1980 and 2000, the company’s revenues increased at a 16.6 percent compound annual growth rate (CAGR) from $213 million to $4,628 million, and its net earnings increased at a 16.5 percent CAGR from $28.4 million to $603.1 million. To remain low cost during the two decades, Southwest stressed simplicity. To reduce maintenance and training costs, it owned and flew only one model of aircraft: Boeing 737s. To avoid congestion, it used smaller airports, in Dallas preferring Love Field to DFW and in Chicago preferring Midway to O’Hare. To save booking costs, Southwest was one of the first airlines to sell tickets over the Internet and to issue ticketless tickets. Also, passengers were not able to reserve assigned seats, but instead selected their own seats on a first-come, first-serve basis upon boarding an aircraft. To further reduce costs, the company built its own computerized reservation system. If you are in a commodity business, the winners are those with the lowest costs—and Southwest had very low costs and was a winner.

The following story is instructive of Herb Kelleher’s inventiveness and style. In March 1992, shortly after Southwest started using the motto “Just Plane Smart,” Stevens Aviation Inc., a company that maintained aircraft and that had been using the “Just Plane Smart” motto for a number of years, threatened to sue Southwest for violating its trademark. After some discussions, instead of a lawsuit, Herb Kelleher and Stevens’s CEO Kurt Herwald decided to settle the argument though an arm-wrestling match at the Dallas Sportatorium wrestling arena. A promotional video was created that showed the CEO’s “training” for the match. In the video, Herb Kelleher is shown being aided by an assistant as he attempts a sit-up. A bottle of Wild Turkey whiskey waits as a reward for each completed sit-up. There were three rounds to the arm-wrestling match. The loser of each round had to pay $5,000 to a charity of his choice. The winner of two out of the three rounds gained use of the “Just Plane Smart” trademark. Kurt Herwald won two out of the three rounds, but he immediately granted co-use of “Just Plane Smart” to Southwest. The result of the arm-wrestling match was that both companies could use the trademark, charities received $15,000, and both companies received excellent publicity.

By 2011, Southwest’s revenues had increased to more than $15 billion, but during the 2001–2011 period, the carrier’s earnings per share (EPS) declined from a peak of $0.79 in 2000 to only $0.40 in 2011. Increased fuel costs and the soft economy were the causes of the sharp decline in earnings.

In August 2012, when Josh entered my office, Wall Street generally was unenthusiastic about the outlook for Southwest, and no Wall Street analyst was predicting a several-fold increase in EPS due to improved pricing. On July 19, the day after Southwest announced its results for the June quarter, several analysts issued reports on the company. The shares were trading at about $9.15 at the time. Goldman Sachs predicted that the company’s EPS would increase to $0.99 in 2014 and valued the shares at $8.50. Merrill Lynch projected that EPS would increase to $1.20 in 2014 and valued the shares at $9.50. Barclays was more optimistic. It projected that EPS would increase to $1.35 in 2014 and that the shares were worth $14. Josh, however, believed that if his thesis on pricing proved correct, earnings could soar far above Wall Street’s estimates. His logic was as follows. The company’s revenues in 2012 were expected to be about $16 billion. For every 1 percent increase in ticket prices, Southwest’s pretax earnings would increase by $160 million and its net earnings would increase by about $0.13 per share, assuming an effective tax rate of 39 percent and a diluted share count of 745 million. Josh believed that as the demand for domestic air travel continued to approach capacity, ticket prices could increase by at least 4 to 5 percent per year, or 2 to 3 percent above assumed cost increases of about 2 percent of revenues. If real prices increased by 2 to 3 percent per year for four years, then the price increases would add $1.04 to $1.56 to EPS by 2016. Furthermore, Southwest recently had announced a profit improvement program that was projected to increase annual pretax earnings by $1,100 million by the end of 2015. The $1,100 million was composed of three pieces:

1. The company had just acquired AirTrans, another regional carrier. The annual synergistic savings of integrating AirTrans into Southwest were estimated at $400 million.
2. In addition, AirTrans flew a number of inefficient Boeing 717s. Transitioning the 717s to another carrier would save about $200 million per year.
3. Finally, Southwest had found a way to add an additional row of six seats to its 737-800s. The extra row of seats, a new reservations system, and other operational improvements together were expected to add about $500 million to annual pretax profits.

The $1,100 million profit program, if successful, would add about $0.90 to earnings by 2016. Based on these estimates and assumptions, Josh concluded that there was a reasonable possibility that Southwest’s EPS could increase from about $0.60 in 2012 to more than $2 in 2015 and to more than $2.50 in 2016, before other considerations. And there were two other considerations. The first was normal demand growth over the next several years. The second was that Southwest, which had as much cash as debt and which was generating large amounts of excess cash, had established an aggressive share repurchase plan. Josh estimated that the repurchase plan could reduce the diluted number of shares outstanding from 774 million in 2011 to materially below 700 million in 2016. Josh commented that the growth in demand and the share repurchase plan were icing on an already delicious cake, and they gave him some extra confidence that if prices increased by 4 to 5 percent per year, Southwest’s EPS could exceed $2.50 in 2016.

Josh then used a second methodology to check the reasonableness of his projections. He estimated that Southwest’s revenues would grow to about $19.5 billion by 2016. During the three years before the 9/11 terrorist attacks, Southwest’s operating profit margins ranged between 16.4 percent and 18.1 percent. Josh reasoned that if he were correct that industry conditions would turn strong, Southwest’s profit margins could return to the 16 to 18 percent level, and thus its operating profits in 2016 could be in the range of $3,200 to $3,500 million. After subtracting $125 million of interest expense from the $3,200 to $3,500 million of operating profits, after deducting taxes at a 39 percent effective rate, and based on an estimated diluted share count of 675 million, Josh’s second methodology concluded that Southwest’s estimated EPS in 2016 would be $2.75 to $3.

Josh also mentioned that he briefly analyzed the fundamentals of the three other large U.S. domiciled airlines, and while each also would materially benefit from increased pricing, each had a precarious balance sheet. For example, on June 30, 2012, Delta had $8.8 billion of net debt and a tangible book value of negative $11.0 billion. United had $4.3 billion of net debt and a tangible book value of negative $3.3 billion. American was in bankruptcy. Southwest, by comparison, had no net debt and had a tangible book value of a positive $5.9 billion. Josh believed that if the airline industry hit an unexpected bump, such as a spike in fuel prices, a terrorist attack, or a sharp recession, the airlines with the precarious balance sheets might be forced into real or quasi bankruptcy, with the result that their shareholders might suffer material permanent losses. Josh believed that Delta’s and United’s shares possibly had even more upside potential than Southwest’s, but they were not for us. Greenhaven hates permanent loss.

Josh attempted to value Southwest’s shares. What was the value of a gem of a company in a miserable feast-or-famine business? Josh did not have the foggiest idea. Neither did I. We did not have a reasonable approach to valuing the shares. However, we did not need to. If Southwest earned anything close to $2.50 per share in 2016, the shares likely would appreciate sharply—possibly several-fold from the present price of about $9. And, equally important, the company’s quality and balance sheet would provide considerable protection against permanent loss. We thought we had a winner—a possible home run.

Josh set up a telephone call with Tammy Romo, Southwest’s chief financial officer. We peppered Tammy with questions, trying to find a hole in our analysis. We did not find a hole. In fact, the more we learned and thought about Southwest, the more we concluded that its reward-to-risk ratio was particularly favorable—in fact, compelling.

So, I did not throw Josh out of my office, but instead soon started purchasing Southwest’s shares. If you had asked me a year earlier whether Greenhaven ever was likely to own shares of an airline, I would have said, “No way.” But I believe that investors sometimes need to be open to new ideas that challenge previous convictions. In the investment business, as in life, one becomes disadvantaged if one develops tunnel vision.

Soon after we established a position in Southwest, I told my 15-year-old grandson Grant about the purchase. Grant was 6 feet 1 inch tall and had the frame of a football player, which he was. Grant had an immediate adverse reaction to Southwest: “Eddie (all my grandchildren call me by my nickname), Southwest’s seats are cramped, and you must arrive at the gate at least an hour early to get a decent seat; I call the airline Southworst.” Well, most passengers are not football players and, unlike Grant, most have to pay their own fares and therefore appreciate the airline’s low discount prices, even if they cannot reserve a seat ahead of time.

The price of Southwest’s shares started appreciating sharply soon after we started establishing our position. Sometimes it takes years before one of our holdings starts to appreciate sharply—and sometimes we are lucky with our timing. In the case of Southwest, we were lucky. The stock market turned strong in early 2013, and some investors became optimistic about the intermediate-term outlook for the airline industry. Most of the Wall Street firms, however, still were not projecting that the airlines would be able to sharply increase their prices and earnings. For example, between the fall of 2012 and the spring of 2013, Goldman Sachs’s analysts slightly decreased their 2014 EPS estimate for Southwest from $0.99 to $0.95. On October 7, 2013, while Goldman’s analysts wrote that they were encouraged by Southwest’s present pricing discipline, they increased their 2014 EPS estimate by only a few cents to $0.98. Then, on October 24, Southwest announced that the company had earned $0.34 per share in the third quarter of 2013, up 161 percent from $0.13 in the comparable 2012 quarter. Virtually all of the large increase in EPS was due to price increases. According to our calculations, prices per revenue passenger mile increased by 8.6 percent if one adjusts for changes in the price of jet fuel. On the day of the earnings release, Goldman finally started to get the message and increased its 2014 EPS to $1.12. The price of Southwest’s shares rose 3.7 percent on the day of the release, and the shares now were selling at about twice the price they were selling at on the day Josh first walked into my office with a broad smile and the idea. Goldman and most other Wall Street firms had failed to predict that ticket prices would increase sharply due to a tightening market. In my opinion, Goldman’s analysts had been so focused on Southwest’s recent developments that they had failed to step back and correctly analyze and predict the critical fundamentals that would determine the intermediate-term price of Southwest’s shares. They had become reporters of recent news, not analysts.

On with the story. In the fourth quarter of 2013, Southwest’s ticket prices increased by 6.4 percent (again, adjusted for the price of jet fuel), and ticket prices continued to increase at favorable rates in early 2014. By the spring of 2014, Wall Street generally had become more aware of the new momentum in prices and profitability. Common EPS estimates for 2014 had increased to about $1.50, but most firms still were projecting only modest EPS gains after 2014. Goldman Sachs, for example, was projecting $1.50 for 2014, $1.72 for 2015, and $1.86 for 2016. Josh believed that if $1.50 was the correct estimate for 2014, then normal annual growth, plus the $1,100 million profit improvement, plus share repurchases would result in 2016 EPS far above Goldman’s $1.86 before any additional price increases—and he thought it logical that the domestic airlines would continue to increase ticket prices as the market continued to tighten.

In late spring, Josh, Chris, and I spent considerable time thinking about our investment in Southwest. At the time, the shares were selling at $25 to $26. We tried to estimate what the shares would be worth in a year or two, but we ended up being befuddled. We had no methodology to estimate what the company’s earnings would be in a normal environment. The airline business had been a feast-or-famine (and mostly famine) business, and there had been almost no periods of normalcy. Moreover, while we had methodologies to value excellent companies in excellent businesses and excellent companies in mediocre businesses, we did not have an approach to value an excellent company in an absolutely miserable business.

Finally, we decided to sell about half of our holdings in Southwest. The shares had appreciated by far more than our other holdings, and thus they had become too large a percentage of our portfolios given the normal unattractiveness of the airline business. And with the price of the shares up nearly threefold from the day Josh first adopted his thesis, their risk-to-reward ratio was not nearly as favorable as it had been. Often, when I am in a quandary about whether to sell one of our holdings, I sell half or some other fraction that makes sense under the circumstances.

The price of Southwest’s shares continued to appreciate during the summer of 2014, reaching close to $35 early in the fall. The company was doing better than we had expected. Demand was strong. Capacity was tight. Prices were firm and increasing. The cost of jet fuel was declining some. We knew all this, but so did other investors. The good news was out, the shares no longer had a favorable risk-to-reward ratio, and we decided to sell the remainder of our holding.