Investing luminaries such as Warren Buffett have always preached the benefits of investing in companies whose products you love. But, while I may relish taking advantage of easyJet’s (LSE: EZJ) insanely cheap flights around Europe, I won’t be touching shares of the budget carrier or its competitors in 2017.
Why? For the same reason that Buffet has long avoided airline shares — they’re highly cyclical, and carriers have a long-repeated tendency to unsustainably increase capacity during the good times only to be left holding the bag when demand growth slows. And I believe this is the exact pattern that we’re seeing occur right now with easyJet.
The carrier’s Q1 results for the three months to December showed revenue growing by 7.2% year-on-year to £997m. However, while this may seem like great news, investors should be wary because it was driven entirely by an 8.6% year-on-year increase in capacity. In fact, average revenue per seat fell a full 8.2% in constant currency terms as easyJet was forced into a fare war with competitors such as Ryanair as slowing demand growth from passengers led to bitter competition to fill seats.
Unfortunately this problem isn’t likely to abate in the near term — easyJet alone is expected to increase capacity by a total of 9% of in the full year. With competitors similarly increasing capacity, passenger growth forecast to continue falling, the weak pound taking its toll and fuel costs rising, expect more pain ahead for European budget carriers.
Revenge of the regulators
The problem for sector-leading CFD trading platform IG Group (LSE: IGG) is also due to external headwinds, which in this case stem from proposed FCA regulations that would significantly constrain the products CFD platforms could offer retail clients. This makes considerable sense, as the FCA says that more than 80% of retail investors using such products end up losing money, so IG Group and competitors shouldn’t expect regulations to be watered down too much.
The company seems to realise this and is pulling high-risk products such as binary options trades, and is making a concerted push into offering less controversial products such as smart beta ETFs and more conventional stock-broking to clients. But the million pound question to be answered in coming quarters is whether or not this will be as profitable as IG’s core leveraged trading business.
The upside for more risk-hungry investors is that IG Group is still solidly profitable with pre-tax profits growing 6.7% year-on-year to £105.2m in the six months to November. And, with share prices down a full 25% over the past year due to the proposed FCA regulations IG Group shares are looking quite cheap at 11.6 times consensus forward earnings.
IG Group has a history of evolving its business model over several decades, but high levels of uncertainty over proposed regulation to leveraged trading products by regulators in the UK and Europe means I’ll be avoiding the entire sector for the time being despite ultra low valuations.