Watch Out! Don't Blindly Play the 'Reopening' Trade

May 19, 2021

Aditya Vora, Research analyst

Last weekend, I was on a skype call with a friend in London.

To my surprise the background in the video call was the lush green landscape of Regents Park in Westminster.

The park was buzzing with positive energy. In fact, I had never seen my friend so jovial and happy in the past 1 year.

"The sun is out and masks are at home" he exclaimed

Now this is in contrast to my previous video calls with him where the only topic of discussion was lockdown, deaths, and fear. The only background I saw while talking to him was his wooden closet.

We spoke about a range of topics from the economy to inflation to bond yields. The conversation ended with my friend telling me about his vacation plans to Scotland. He had booked Airbnb for a month.

This last piece of information got me thinking about the so called reopening trade.

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It was actually playing out. People were so fed up that they needed a getaway.

The US and many European countries are past their 3rd wave along with increasing vaccination numbers.

The idea of taking a holiday, visiting a theme park or theatre or just shopping for luxury items is coming back with a bang.

Last year, conversations were centered on being safe.

Now with fear receding and safety levels rising, this year and the next would be about enjoying life.

I'm a bit philosophical but covid has taught us that life is unpredictable. So we should make the most of it.

But how do we seize the opportunity thrown up by the reopening of the economy? How do we make money from last year's fragile stocks?

To give you some perspective, when Disney Land Florida re-opened bookings in March, it was completely booked till mid-April.

I am sure you must have seen the pool party in Wuhan last year. The epi center of the virus with a population of 11 million residents saw one of its biggest pool party in August 2020.

Thousands of Wuhan residents were seen partying without masks. It was called a 'strategic victory', a mark of revenge against Covid.

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Unfortunately, in India, we are in the middle of the 2nd wave. However, it's promising to see the numbers trending down since the past 10 days.

With vaccination picking up pace and as more and more players entering into collaborations to produce vaccines, the question is 'when' and not 'if' we will win the battle against the virus.

Intuitively, the airline, hospitality and multiplex sectors will be the best way to play the theme.

When things open up, I am sure many of us are eagerly waiting to jump on the next flight for a holiday.

The fatigue of watching OTT shows at home TVs has set in. The urge to see our favourite superstars on big screen with surround sound and a bucket of overpriced popcorn is very much there.

It's been long since I have had my favourite Sushi in a restaurant.

So in that case, logically, the stock prices of these companies should rocket when things open up.

Why not buy them now? After all if demand explodes then stock prices will too, right?

Not really.

Apart from fact that markets have already discounted this narrative, there are a few other reasons too.

Not every company in the airline, hospitality and multiplex sectors will bounce back.

It would be wrong to paint the entire canvas with the same brush. After all, not all hotel stocks are good for the long term.

Let me illustrate this by focusing on two important things that go into making a long term investment decision. These are sustainable demand and valuations.

Example 1: Hospitality

Long term returns of hotel stocks have been below FD rates. This implies wealth destruction, not wealth creation.

Company 10-Jan 20-Jan 10 Year CAGR Returns
Indian Hotels Company 150 95 5%
EIH Limited 143 108 3%

I do acknowledge, the pent up demand from travel will lead to full occupancy for a brief period when things open up.

But can hotels make money for investors on a sustainable basis?

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The hotel business is a very capital intensive. It has long pay back periods which are very sensitive to changes in demand.

The return on capital which is one of the most important factors to judge capital efficiency. It's very low (single digits) for this sector.

It's very difficult to consistently generate good cash flows and have high returns on capital in the hospitality sector.

Also, don't forget the recurring expenses for maintenance is also high. After all, would you visit to a rundown hotel?

Other factors such as competition from Airbnb along with permanent reduction in business travel are long term structural negative factors.

Example 2: Airlines

Did you know that Interglobe Aviation (Indigo Airlines) is the best performing and the most expensive airline stock in the world?

Airline Stocks Six month returns for Aviation stocks in 2020
Interglobe Aviation 85%
Delta Airlines 73%
United Airlines 70%
Southwest Airlines 68%
Alaska Air 64%
Rynair Holdings 51%

This, despite the fact that international travel is restricted and domestic travel has again plunged in April and May 2021 due to the second wave.

Markets have already discounted this and are giving it the benefit of consolidation. Indigo being the market leader with over 50% market share.

However, one important aspect from a long term demand perspective is this...

Business travel accounts for 30% of domestic passenger traffic and contributes to higher realisations.

It's likely to fall permanently by at least 30-40%. That's a net reduction of business traffic of 10% for the airline industry.

People and in turn companies, have got used to running the show digitally. Expenses for business meetings would be termed as waste of money.

I believe avoidable costs like travel could be used by managements going forward as a positive lever for cost savings and in turn higher profits.

In the first half of the last financial year operating costs came down to a bare minimum due to covid.

But in the second half, rising commodity costs put immense pressure on many companies.

Input costs are in control of most companies. Their focus is to shift to cost savings in travel expenses.

The valuations of airline and hospitality stocks are not cheap.

Over the past one year, the balance sheets of these companies have been wrecked.

Going forward, I believe the 'reopening trade' will play out, but for long term investors, fundamentals like sustained demand and valuations would be the key.

The question is many of the positives have been already priced into the lofty valuations of these companies.

Can these stocks really soar higher?

Warm regards,

Aditya Vora
Aditya Vora
Financial Writer

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