Tuesday, October 5, 2010

Altria Outperforms...Again

Bespoke Investment Group recently highlighted Altria's (MO) outperformance (historic and recent) vs the S&P 500.

Stocks like Altria, Coca-Cola (KO), and Pepsi (PEP) among others over the long run (i.e. ideally at least a business cycle or two) tend to outperform the S&P 500. That makes them both good on offense and defense though they are often treated as being just good for the latter.

To demonstrate this, a worthwhile exercise is trying to find a consumer staple stock that has not outperformed the S&P 500 over any 20-year period (usually an easy thing to check these days on a number of financial sites). There are exceptions -- usually caused by excessive valuation at the beginning of a 20-year period -- but otherwise it's actually very difficult to find one that has underperformed. Even mediocre consumer staple businesses tend to do at least okay over the long run.
(Over the shorter run -- less than five years or so -- anything can happen as far as relative performance goes, of course. In fact, during a bull market there's more likely to be a disadvantage.)

From Bespoke Investment Group's post on Altria:

"...MO's historical yearly performance versus the S&P 500 shows just how much of a powerhouse the stock is. Since 1981, MO has averaged a yearly gain (not including dividends) of 18.54%, while the S&P 500 has averaged a gain of 8.77%. In the 23 years that the S&P 500 has been up for the year, MO has outperformed the index 20 times. In the 9 years that the S&P 500 has been down, MO has outperformed the index all 9 times."

The article makes the point that Altria's outperformance excludes dividends. Keep in mind that Altria has consistently had one of the largest dividends among S&P 500 stocks (Altria has routinely had a 5-8% per year dividend on top of that 18.54% annualized return). So it's worth remembering that the simple act of buying shares of a company like Altria for the long haul would have done rather well by any measure.

Also, check out Altria's performance over a longer time horizon. A big part of Altria's long-term performance is, in fact, the combination of a low valuation -- in part due to the fact that there have been no shortage of reasons to NOT own a tobacco stock* during the past several decades -- and a substantial dividend. Well, those dividends could be reinvested when the stock was frequently cheap -- enhancing returns. Buybacks would offer a similar effect. That a consistently cheap stock would enhance long-term returns** may at first seem a bit odd but, well, it's straightforward arithmetic. When the shares of a stable business with sound economics remain cheap for an extended time, the fact that incremental shares can be bought -- via dividends and/or buybacks -- at a discount to intrinsic value improves results for continuing shareholders.***

The compounded effects are not small. The next time shares of a quality holding rallies in the near-term this is worth considering carefully. A near-term increase in price is hardly a good thing for the long-term owner.

Still, the franchises that sell small-ticket consumer products (though, for some, tobacco businesses -- considering the nature of their products -- may not be considered desirable investments for obvious reasons but beverages and candy work just fine), have strong brands, and some real scale tend to be compounding machines. In my view this remains an underutilized approach especially if the investor understands business economics and competitive advantages well enough, can estimate intrinsic value, and has the discipline to always buy at a discount.

In any case, it's not the past performance that matters. What about going forward? The spectacular returns above do seem unlikely going forward.
(Though I don't mind being pleasantly surprised.)

For example, if Altria were to consistently sell at a smaller discount to value (or maybe even become downright expensive) than it has in the past a big part of the reason for the outperformance will have been eliminated. Dividend reinvestments and buybacks will work much less well. So, if the stock does generally remain more expensive, Altria's long-term performance relative to the S&P 500 likely won't look anything like the past.

Compounding is not difficult to understand yet just how powerful it is seems to get underestimated or, at least, underutilized. It may not always be intuitive but can be made to work brilliantly over longer horizons. Knowing this, huge amounts of energy (more than ever, it seems) is still expended on trades that are made over extremely short time horizons where the power of compounding cannot possibly be a factor. So there's this extremely powerful force, that works great passively over time if you buy good assets, yet collectively market participants are trading more than ever. Basically, trusting the power of compounding less than ever. The question is why?

No matter what reasons exist for the above disconnect, it does seem that the advantages of leading consumer staples businesses remain less than fully appreciated. Consumer staples are still routinely thought of as merely defensive stocks even with all evidence pointing to them being both good defense and, at least over the longer haul, good offense as well.
(Some try and jump in and out of so-called defensive stocks depending on whether a defensive posture is warranted or not. Well, at least based upon the number of active market participants who underperform, what might appear a reasonable idea on paper seems difficult at best to put into practice.)

Having said that, I do think the long-term performance of these rather boring businesses naturally leads to questions like:

"How can something that straightforward not be figured out by now?"

or

"That's in past, how can that kind of growth in value continue?"

Well, consider what was said in 1938 about Coca-Cola.

"Some think if an investment idea is well-known and seems obvious it can't be really good. In 1938, Fortune Magazine concluded "Several times every year, a weighty and serious investor looks long and with profound respect at Coca-Cola's record, but comes regretfully to the conclusion that he is looking too late." Since that time, Coca-Cola has grown significantly both domestically and around the world. It was not too late in 1938, and we believe it is far from that today." - From the Yacktman Fund 1Q 2010 Letter

Also, along the same lines remember what Buffett had to say about Coca-Cola when he finally bought it in the late 1980s.


Owning some of the great franchises continues to makes sense for my money but they still have to be bought at a nice discount to intrinsic business value. What's sensible to buy at a discount to intrinsic value doesn't make sense at some materially higher valuation.***

Otherwise, these can be good defense and offense.

What ultimately matters, of course, is how a business and its shares will perform going forward. Getting that at least mostly right still requires plenty of work.

In other words, just because a particular business (or type of business) has done well in the past guarantees nothing.

Adam

Long position in MO, KO, and PEP

Related posts:

Altria vs Coca-Cola - July 2010
Grantham on Quality Stocks Revisited - July 2010
Friends & Romans - May 2010
Grantham on Quality Stocks - November 2009
Best Performing Mutual Funds - 20 Years - May 2009
Staples vs Cyclicals - April 2009
Best and Worst Performing DJIA Stock - April 2009
GM vs Philip Morris (Altria) - April 2009
Defensive Stocks? - April 2009

* For starters, there's the persistently declining volumes along with legal, regulatory, and tax challenges. Then there's the fact that many institutions and other market participants, understandably, don't want to be associated with the tobacco business. Yet the fact that the stock was cheap, returns on capital were healthy, and pricing power remained substantial made it into a fine investment. This may be a bit counterintuitive but there's much to be learned from it. 
** Some think the only way to produce above average returns is by owning part of a transformational businesses. Well, here's a business that's far from transformational, where volumes have been in decline for decades, with huge legal and regulatory risks, and many market participants that are uncomfortable owning the common stock. Yet, despite all this, that stock has still performed very well for long-term owners. Strangely, it is all the negatives that made the shares consistently cheap (making dividends and buybacks more effective) and later the led to the outsized returns. At times, what doesn't quite fit expectations deserves extra attention. Of course, it's always possible that some of these challenges start to really erode Altria's core economics. The past can only reveal so much. That possibility also deserves careful consideration. Altria, along with just about any tobacco business, have a unique set of risks versus other consumer staples businesses. With any investment, no matter how seemingly attractive the core economics may be, margin of safety is all-important. Margin of safety always comes down to the specific risks of each business. This protects against the unforeseen real, even if fixable, serious business problems. Still, it's worth considering this: "If the business earns 6% o­n capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% o­n capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." - Charlie Munger at USC Business School in 1994
*** Depending on the type of account buybacks are generally more tax efficient than dividend reinvestments. Other than the tax differences, buybacks and dividend reinvestments -- implemented at reasonable or better valuation levels (i.e. discount to value) -- similarly benefit long-term owners; the former reduces overall share count, while the latter increases the number of shares owned. Naturally, a continuing shareholder could also choose to commit additional cash to buy more shares when inexpensive.
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