Warren Buffett says this is one behavior that causes airlines to go broke (AAL, DAL, UAL, LUV)

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February 27, 2017 5:53 PM

Warren Buffett has invested roughly $10 billion in American, Delta, United, and Southwest Airlines.

Warren Buffett, chairman and CEO of Berkshire Hathaway.

Berkshire Hathaway Chairman Warren Buffett doesn't often invest in airlines.

And it's for good reason.

According to the legendary investor, the capital-intensive nature of the business and frequent bankruptcies have made airlines a tough buy.

In an interview with CNBC on Monday, Buffett called the industry a "disaster for capital" and said the glamor of airlines makes them attractive for investors.

Although Buffett has made money in the past on his airline investments, he said it's easy for airlines to sink into behavior that's detrimental to their well-being.

"It's a tough business because ... you have these huge fixed costs, and yet, if you take one more person on, there's virtually no cost. So you're very tempted to sell that last seat too cheap," Buffett said. "What kills you is when they have too many airplanes around and [prices] get down to marginal cost, and marginal cost causes you to go broke over time."

Since the marginal cost of increasing seat capacity is relatively low, US airlines have been guilty in the past of flooding the market with excessive seat capacity to boost revenue. However, the increase in capacity outpaced the growth in demand, which led to diminished margins. According to Buffett, airlines should be running their planes with at least 80% of their seats filled.

In the years since the financial crisis, airlines have been far more conscious about capacity. However, with their coffers filled with cash from lower fuel costs, airlines are once again tempted to change the gauge of their aircraft to larger models in an attempt to drive down unit costs. For instance, 50-seat regional jets are being phased out in favor of larger 76-seat models. At the same time, larger variants of the Airbus A320 and Boeing 737 families have vastly outsold their smaller siblings.

However, it remains to be seen if airlines are up to their old tricks.

In 1989, Warren Buffett invested $358 million in US Air, now a part of American Airlines. Even though Buffett made a quite a bit of money on US Air when he sold in 1998, he said the hypercompetitive nature of the industry made for an unpleasant investment experience.

Over the past six months, Berkshire Hathaway has invested roughly $10 billion in American, Delta, United, and Southwest. As Buffett said in the interview, all but Southwest have spent a considerable amount of time in bankruptcy over the past two decades. Southwest has reported more than four decades of continued profitability.

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