It’s a well known secret that one of the single best investments you could have made over the past fifty or sixty years was to buy and hold Philip Morris stock (LINK) . Had you invested $1,000 in the late 1960s, and continually reinvested the dividends along the way, then your holding would be worth roughly $7,000,000 + today. The sheer scope of those returns – compounding at a rate of about 20% a year – is unmatched by any other stock in the S&P 500. (Check the stock return calculator here – please note Phillip Morris was part of Altria (MO) before the 2008 spinoff).
Credit Suisse published a report in 2015 detailing the performance of every major American industry from 1900 to 2010.
One dollar in the average American industry was worth $38,255 by 2010. That’s an annual return of about 10% per year. Some did far better: $1 invested in food companies was worth about $700,000 by 2010.
Then there’s tobacco, which was in a league of its own.
One dollar invested in tobacco stocks in 1900 was worth $6.3 million by 2010. That’s 165 times greater than the average industry.
Think about everything that has changed in the past one hundred years! We went from horse and buggies to cars to space travel, the Internet, nuclear knowledge, and a whole lot more. It was a century of innovation and excitement. Yet the best performing industry was one that was resistant to change – cigarettes.
This shouldn’t come as a surprise. I have written before on Dr Jeremy Siegal’s research (LINK – CONSUMER Staples) which showed that investments in consumer staples, and in specific tobacco, have provided the best historical returns for investors.
Furthermore, as a cautious long term investor, it is great to know that the tobacco sector has not had a single negative 10-year period from 1926 – 2015. In fact the worst 10-year period from 1926 – 2015 for tobacco stocks still returned 1.3%. Nothing special, but not negative. On the other hand, the worst 10-year period for the market overall was about -5%. Tobacco certainly fits the criteria of having a good probability of keeping ones principal intact at the end of a holding period. As Buffet once said, “Rule number one is to never lose money. Rule number two is to never forget rule number one.”
So why are tobacco companies so successful?
The tobacco industry has been successful for two main reasons.
1. The Economics Of The industry Are Extremely Attractive
To sum up the economics of the tobacco industry you only need to read this one quote from Warren Buffett: “I’ll tell you why I like the cigarette business. It cost a penny to make. Sell it for a dollar. It’s addictive. And there’s a fantastic brand loyalty.” Those five sentences pretty much encapsulate one of the most profitable industries in history. It’s candid, particularly in the context of addiction, but if you’re looking for what makes a wide-moat business then this describes it perfectly.
I have written about the economics of the tobacco industry before so go and have a look at that post before continuing. It shows that tobacco companies have earnt above average returns for long periods of time due to regulation protecting their moats.
What happens when you ban advertising of a particular product – in this case cigarettes? Well, you get no new competitors. No company will want to enter the cigarette industry as they are unable advertise their products. This means that the existing players are able to operate at double digit profit margins as they have no fear of new companies coming in to eat their profits.
Furthermore, most countries are moving towards hiding cigarettes behind a counter. This means only the strongest brands will survive. So if you go to a different city, county or country – or any shop for that matter which isn’t your local – you will simply ask for a pack of Marlboro because you will know they will have it. Most people don’t want to look stupid by asking a sales assistant what brands they have hidden behind the counter. This bodes well fro Phillip Morris which owns the Marlboro brand – The No1 cigarette Brand in the world.
2. Ethical Investing.
I mentioned above that Warren Buffet thinks that the economics of the tobacco industry are wonderful. So why doesn’t Warren Buffet own tobacco stocks? In short, Buffet doesn’t want the stigma of being associated with a tobacco company to ruin his reputation. After all, Warren Buffets greatest asset is his reputation. His reputation allows him to get deals that no one else can. His reputation allows him to garner trust in whatever he invests in . His reputation is a seal of approval. And he won’t do anything to ruin this reputation he has built over a lifetime.
Likewise, a lot of the very big investors – pension funds, sovereign wealth funds – that control trillions of dollars worth of assets want nothing to do with tobacco companies. Many of these deep pools of capital are banned from investing in tobacco.
As the biggest players on the stock market cannot own tobacco stocks, valuations of companies in the industry are low (due to low demand). Low valuations lead to high free cash flow and dividend yields. And high dividend yields, compounded over decades, add up to massive returns.
I have written before on why sin stocks outperform. It is for the exact reason that people don’t want to touch them. They are hated as an investment category. And history has shown that the more hated an investment is, the higher future returns are likely to be. The same is true vice versa. This is one of the most difficult investing concepts to come to terms with, but probably the most powerful.
The above two are the reasons for the tremendous performance of tobacco stocks. Over the past century, the resilience of cigarette companies were highly underestimated. With the onslaught of regulation, health warnings and high taxes on tobacco product, tobacco was seen as an industry suffering a slow death. Tobacco stocks were trading at 7%, 8% and 9% dividend yields and single digit p/e ratios. Yet looking under the bonnet and perking at the accounts, you could see that the wonderful economics that surrounded the industry still existed. Companies were still growing profits. Free Cash Flow was close to a quarter of revenues. Returns on incremental capital employed remained the highest of industry. Competition was shrinking due to consolidation and regulation. It doesn’t take a rocket scientist to figure that investors buying shares on the cheap in wonderful enterprises will reap long term rewards. And that is exactly what happened to investors in tobacco companies.
Phillip Morris – A Bad Year
To say tobacco stocks have had a bad year is an understatement. The two biggest players, Phillip Morris and BAT have seen their stock prices fall by over 30%. A confluent of factors have led to this. Rising bond yields – which lessens the appeal of tobacco stocks’ hefty dividend yields, – increased regulatory concerns, increased health awareness and disappointing financial performance (mainly due to the strong dollar) have combined to push the stocks to their worst performance in more than a decade
Even the proxies to the tobacco industry are faring badly. Swedish Match, owner of the worlds largest match and lighter showed double digit volume declines in its matches and lighters business in the quarter to March 2018. This is certainly a material decline. And it should certainly give a good indication as to what is happening in the tobacco industry.
Furthermore, there is major concern amongst investors about the continual decline in smoking rates due to the emergence of new trends such as vaping. There are fears that tobacco companies can no more simply increase prices of packs of cigarettes to make up for the lost smokers due to prices already being high – particularly in western Europe.
From the above, it is easy to see why shares in tobacco companies have been dropping. But the biggest factor in all of this and the reason I personally think tobacco stocks have dropped in price is due to valuation.
Tobacco companies have had a stellar run, particularly over the two years to June 2017. This lead to tobacco companies being richly valued and overpriced. There valuation crept well above long term averages as investors were keen to bid up prices for fear of missing out on the bull run.
So the recent de-rating of tobacco stocks is business as usual. With the recent fall in prices, valuations of tobacco stocks have come back down to around 14 which is in line with their average rating over the last 10 years. Before this derating, tobacco stocks were spotting P/E ratios above 20! This is absurd. As mentioned earlier in the article, tobacco stocks have performed well throughout history mainly due to their lowly rating.
As for the fears surrounding declining smoking rates and regulation, we have been here before. Regulation has traditionally been a boon to cigarette companies and there is no reason to think that the tide has turned. As for declining smoking rates, the headlines can be misleading.
Yes, I am not disputing the fact that smoking rates have been on the decline for many years. But it is just that, smoking rates have declined, not the number of smokers. There is a big difference. So whilst the percentage of people who smoke is on the decline, the WHO and other health bodies estimates that the number of smokers are actually increasing worldwide. That’s because the population is rising, meaning that even as smoking rates decline in percentage terms, the actual number of smokers is actually increasing. Funny thing statistics and headlines hey!
As for the threat of vaping, I think it is real and it’s a positive that the big tobacco companies are taking it seriously by developing their own products. Phillip Morris is going further by developing IQOS product. It is a heat not burn product which is to say is heats tobacco at a lower temperature than when a conventional cigarette is burnt. The product still contains the nicotine that the smoker craves but it’s aim is to certainly be healthier than smoking a traditional cigarette. The reception of IQOS so far – particularly in Japan – has been great and Phillip Morris certainly see this product as a huge driver of future growth.
My Purchase Of Phillip Morris Stock
With the recent decline in price of Phillip Morris Shares, the company has become attractively valued. I wouldn’t call it cheap just yet due to the debt it holds on its balance sheet, but it is certainly one of the most attractive investments available on the market.
With the current price at $78 a share, I expect Phillip Morris to comfortably produce double digit returns over the medium and long term and in the process outperform he market.
I bought 21 hares in Phillip Morris for $78 (or £60) a piece. For this outlay, I expect to receive an annual dividend income of £71 over the next year. And like any quality business, I expect Phillip Morris to continue to grow its dividend year after year.
What is great about owning shares in Phillip Morris, is that unlike most US listed companies, there is a significant chunk of the dividend which is exempt for dividend withholding tax. This is because Phillip Morris is a “80/20 company”
Phillip Morris – A “80/20 company”
So what exactly is a 80/20 company?
An “80/20 company” is a U.S. company 80% of whose gross income for a specified period is generated from active businesses outside the United States.
At present, because nearly all of Phillip Morris income is earned in active businesses outside the United States, the company has determined that it qualifies as an 80/20 company for U.S. tax purposes
As such, Phillip Morris has determined that 97% of any dividend it declares in 2018 to a non-U.S. shareholder is exempt from U.S. withholding tax.
This means that the remaining 3% of the total gross dividend is subject to U.S. withholding tax at the 30% statutory rate, unless the non-U.S. shareholder provides a Form W-8BEN claiming a reduced rate of withholding under an applicable income tax treaty. In the UK, if you have submitted a W-8BEN form to your broker, you are only charged 15% rate on US dividends.
All this means that there is more dividends for me. And that is exactly what I like.