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Loss Aversion: the B737MAX & PSR “Precision Scheduled Railroading”

The Foundation of Investment Decisions

Strategic decisions are never simple.  Despite the significant resources investment managers devote to the decision process, they often make judgments that go wrong because of human shortcomings.  Behavioral economics teaches that human biases, such as over-optimism about the likelihood of success, often affect the decision process, and employee incentives may be misaligned with long-term investment results.  

Most investment managers know about these pitfalls.  Yet cognitive bias distorts the way managers collect and process information, and judgment often is colored by self-interest.  Overoptimism and loss aversion (the human tendency to experience loss more acutely than gain) are the causes. All investment decisions have two essential components: the likelihood of the expected outcome, and the value placed on it.  When investment probabilities are based on repeated events optimism may be less of a factor. 

The Impact of Loss Aversion

But loss aversion also influences investment decisions.  Consider Boeing’s design and marketing decisions for the 737MAX.  Did Boeing sacrifice safety and airframe design principles to meet competitive pressures from the Airbus A320neo?  Boeing and Airbus operate a ‘duopoly’ in the market for single-aisle jets (valued at over $3.5 trillion over the next 20 years).  Neither can afford to fall behind.  Boeing had considered the single-aisle market large enough to launch a new aircraft design (New Midsize Airplane, “NMA”).  But in 2011, when American Airlines announced a record order for 460 single-aisle planes from Airbus (260 A320, 130 of which were the A320neo) and 200 737s from Boeing, Airbus had managed to break the longstanding monopoly Boeing had with American.  

The Airbus order, “loss aversion’ and market forces forced Boeing to commit to revamp its best-selling 737 with new engines rather than develop an all-new NMA.  Analysts had said that developing an all-new replacement for the 737 would have cost Boeing as much as $12 Billion. But with the 737MAX grounded world-wide since March 2019, Boeing has now booked $9.2 billion in charges.  In the rush to meet market competition Boeing opted not to develop the new jet.  Now, Boeing may still be required by regulators to re-approve the plane as a separate aircraft type from the 737 family.

Mitigating Risk

As investment decisions are evaluated, a misalignment of time horizons frequently leads to the wrong decisions.  Short term paybacks are favored over the impact decisions may have on longer investment horizons. Precision scheduled railroading (“PSR”) promises to improve operating ratios, train speeds, and yard through-put.  But the Rail Industry is not addressing how to provide delivery precision to the final railway freight shippers’ docks.  Boeing’s re-engined 737 and the Class One’s PSR implementation are examples of optimizing short-term performance at the expense of customer relationships and longer-term corporate health.  Boeing feared the loss of market share and Class One’s fear of being left behind. This ‘loss aversion’ phenomenon can lead decision-makers astray. 

Be reluctant to ‘bet the farm’ on these larger decisions.  Minor decisions can be managed as part of a long-term diversified risk-mitigating strategy.  The way to become better is by using tools and techniques that create a culture of constructive debate.  Initial assessments should be supplemented with independent second opinions.  

The economics of transportation equipment investment are complex.  Take a fresh look and ensure the right questions are being asked and answered.  When does it make sense to take risks? Call RESIDCO.  

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2020 Equipment Values

Value Forecasting

Residual value forecasting for transportation equipment often begins with an expected value curve that traces ‘value decay’ over an asset’s assumed useful life. Once the basic value curve is in place, value volatility must be considered and incorporated (value decay curves do not provide an accurate forecast since the value of transportation assets doesn’t always go down).  

Overlaying volatility allows an estimate of the range of expected value at any point, given the impact of expected changes in market factors and customer needs on specific equipment types in the portfolio. The economics of an investment requires lessors initially measure their residual as the present value of the amount that they expect to derive from the underlying asset following the end of the lease term; This is a value that is not guaranteed by the lessee or any other third party unrelated to the lessor, discounted using the rate implicit in the lease. An investor’s individual risk tolerance affects residual values that eventually are incorporated in the economics of lease return calculations. At the same time, accounting recognizes book income during the life of a lease based on the assumption that residual values will be realized, unless ‘impaired.’  

Aircraft values were impacted by the events of 9/11 and by the 2008 global financial crisis.  Passenger and freight traffic tumbled, and airlines parked their jets by the hundreds and returned leased planes as lease contracts expired.  Yet over the decade following 2008, the global airline industry logged ten consecutive years of profitability. 

Effects of Equipment in Storage

Today, as CSX, Norfolk Southern, and the Union Pacific implemented Precision Scheduled Railroading, they are storing or returning locomotives and freight cars, idling yards, and laying off employees.  On December 1, 396,200 railcars were in storage, almost 25% of the 1.7 Million car fleet (storage levels last peaked in 2016 at 425,000 cars). The future economics of these car types are complex. Of the railcars in storage, 35% are Covered Hoppers, 28% Tanks, and 12% Coal Gondolas.  

Equipment in storage, whether a locomotive, railcar, or a 737MAX that is not flying, is worth less than if in service.  Planes are built to fly. Once recertified, it will take 100 to 150 hours of additional work for each 737MAX to return to flight. Maintenance must spool the engines and boot up a flight computer and auxiliary power units every week.  Exterior surfaces and cabin interiors must be protected. The longer in storage, the more maintenance needs to be done.  

Are These Assets Impaired?

“Impairments” are recognized only if there is a “permanent” reduction in value (the amount of an impairment loss being the difference between an asset’s carrying amount and its current fair value).  With a 30% decline in value, an investor who is leveraged 2:1 would experience a 60% decline in net worth if they were to take a write-down. Bank lessors, who are typically leveraged 10 to 1, will elect to store their equipment rather than sell into a down market.  Next year’s equipment values will be impacted by the existing fleet, new equipment demand, the business cycle, and the always unpredictable ‘unexpected’ events.  Strategic thinkers leverage experience, judgment, and proprietary data to manage residual risk and achieve investment goals.  Call RESIDCO. 

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A Decade of Disruption and What To Expect

“A new decade stretches before us.”  Crosscurrents from the past decade have swept the unprepared away, so a review of the past decade’s challenges will help instruct future investment. Optimizing investment management will always require a deep understanding of markets, end-user needs, current fleet dynamics, and equipment designs. 

Boeing’s 737MAX, the Class One’s singular focus on reducing operating ratios (using Precision Scheduled Railroading), and Commercial Banks focus on earning asset growth (without the tools to fully understand and manage operating investment risk) are examples of mismanagement producing unexpected results. Over the past decade, low-interest rates, private equity, and banks in the operating leasing business have driven yields down. While politics and economics have dominated the news, the following major trends will continue to influence the next decade’s investment decisions.  

Technology will drive greater efficiencies and transform customer expectations. Cloud services, information management, data analysis, and the continuing impact of the internet will influence the process and means of global supply chain management.  Smartphones and email have created more frequent communication, increasing employee productivity, and making business operations easier.  As weather patterns change, reducing carbon emissions will continue to impact air, rail, and marine transportation equipment design decisions. The GE/Safran (CFM) LEAP 1-A and the Pratt & Whitney Pure Power 1100G, geared turbofan are examples of new aircraft engine designs engineered to be more fuel-efficient, quieter, and lower maintenance than current engine options.  

Energy.  The shale oil boom has sent shockwaves through the energy landscape.  Domestic energy sources (shale oil and natural gas) now promise abundant and inexpensive supply.  It’s turned coal car investment on its head.  But for the next decade, petroleum will remain the primary source of energy for transportation (aviation, diesel, and motor gasoline).  

Free markets, social stability, the rule of law, and continuity of effective cooperation drive economic growth.  Regardless of a phase one trade agreement, China’s Communist Party will continue to pursue a China first policy.  With low labor costs, forced transfer of technology, and intellectual property theft, U.S. policymakers have allowed China to become the world’s largest exporter of goods.  What was an attempt to open the Chinese markets to U.S. investment has instead led to the pain of disappearing U.S. manufacturing jobs, and Economic Nationalism.  

Government spending.  Fiscal policy, interest rates, financial markets, and future tax laws will be driven by the trillion-dollar deficits projected for each year beginning in 2022.  Demographic changes (resulting from lower birth rates and diversity caused by immigration) will impact our common social identity, driving populism and political polarization. 

Some things remain.  The benefits of leasing: lower capital cost, less maintenance, and human resource issues, equipment that is kept up to date, access to the latest design and management expertise.  Another constant? Individuals, businesses, and countries will continue to make choices based on maximizing self-interest (A rational analysis should not ignore that humans sometimes rely on emotions rather than facts).  We’re in a game with many innings yet to be played.  

Guard against groupthink.  Invest in assets that generate long term value.  Call RESIDCO. 

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