Friday, July 25, 2014

Altria: Timing Isn't Everything, Part II

A follow up to this post. To me, what's of interest when it comes to Altria (MO) isn't just that it has done very well over longer time horizons in terms of risk and reward, it's what can be learned from it and applied elsewhere.

In the earlier post I noted the following:

- $ 10,000 invested in Altria increased to $ 80 million (incl. reinvested dividends) over roughly fifty years ending in 2006.

- The stock, including the impact of reinvested dividends, has more than tripled since the end of 2006.

Quite an outcome. These results are unusual if for no other reason that the business itself has faced so many headwinds for so long.

That, to me, is what makes Altria worth better understanding.

Studying what doesn't quite fit expectations sometimes leads to useful insights.

"The thing that doesn't fit is the thing that's the most interesting, the part that doesn't go according to what you expected." - From The Pleasure of Finding Things Out by Nobel Prize winning physicist Richard Feynman

I mean, the kind of difficulties Altria has faced (and, to an extent, continues to face), at least on the surface, would seem to not be correlated with such an investment outcome.

As I also noted in the earlier post, the things working against Altria might eventually spell real trouble for investors. It's worth careful consideration. Even though things have worked out great investment-wise for a very long time, maybe owning shares of Altria will eventually become a dumb thing to continue doing.

My view is that time spent trying to prove that thinking is flawed beats trying to reinforce its correctness every time. Those seeking what's consistent with their own views tend to pay for it later in the form of much reduced returns. So read and think about what challenges and raises doubts about investing ideas; pay less attention to what seems to confirm.

Now, it's also possible that Altria's inherent business strengths mostly remain in place. In the past, those who've put too much weight in Altria's challenges (and mostly ignored the advantages) have greatly benefited continuing long-term shareholders. The "story" remains not very compelling. Why things have worked so well for investors long-term isn't terribly intuitive. The core product is still not at all good for its users. Volumes have been declining for a very long time and should continue to do so. There have been and remain many legal, tax, and regulatory challenges. 

Yet none of this is really new. These days, U.S. smokeable products is the biggest driver of value for Altria in its current form. With the two big spin-offs back in 2007 and 2008, that now IS a relatively new consideration. Smokeless products and the SABMiller (SBMRY) stake also make meaningful but much smaller contributions to value. Wine makes a very small contribution.

So, prior to the spin-offs, food products and international tobacco products were once a big part of the story. 

Well, that means Altria can no longer lean on those other businesses if the U.S. smokeable products business gets in trouble.

Altria's long-term results mostly comes down to pricing power, very high returns on capital, and a persistently low stock price relative to earning power (a discount to intrinsic value).*

The pricing power has, on average, at least up to now, more than made up for volume declines. Naturally, there are limits to pricing power, but those who can increase price successfully will see it mostly (if little or no marketing spending is required), if not entirely, fall to the bottom line. Revenue that comes via volume increases generally have a bunch of associated incremental cost of sales. So, for the business with pricing power, a 3% increase in revenue from additional volume is inferior to a 3% increase in price that mostly sticks.

It naturally may make sense for a particular business to pursue both, but available pricing power is sometimes an underutilized lever. Revenue generated from incremental volume is usually, by comparison, rather hard work (and not necessarily high return).

Sustainable pricing power in combination with low capital requirements usually creates attractive business economics. Well, Altria has both. The business of producing and selling small ticket consumer products (even after all the price increases over the years), with brand loyalty, strong distribution, and scale can come with not insignificant competitive advantages.

Now, growth is frequently thought of a desirable characteristic for a business. On the surface this makes sense. Well, if growth is such an important and wonderful thing, why has Altria done so well?

How many potential new competitors are going to be interested in competing in an arena with a shrinking pie, big legal, tax, and regulatory risks, where it's tough to build a new brand? Due to tobacco marketing restrictions, it's tough for a new entrant to the industry to build an alternative brand and gain significant market share.** Excise taxes alone make up a big part of the per unit cost. That makes its tougher to come in with a low cost alternative to take significant market share from established brands.

Does consumer behavior change for a few cents savings when it comes to something as personal as taste?

Probably not.

Even if it did change behavior, would the economics make it worthwhile for the new entrant?

Doubtful.

Reduced competitive pressures contributes to persistent pricing power.

Technology businesses deal with constant change. This creates big winners and, well, many losers.

Even those who can pick the winners beforehand too often pay a high price for the privilege.

That technology businesses overall tend to have lower long-term returns is likely, in part, due to lots of disruptive competition and the fact that the current winners are often priced for greatness.

Sector Returns (1963-2014)
Consumer Staples: 13.33%
Technology: 9.75%

Consumer staples had the highest returns among the ten sectors.

Yet they're routinely referred to as defensive. Well, thinking of them as defensive isn't wrong, it's just incomplete.

Technology had the lowest returns among the ten sectors.

The future may be very different, of course, but the point is that fierce competition and technology shifts can turn sound core business economics into something else altogether.

High returns on capital today; rather the opposite down the road.

New competitors and capital usually go where there's exciting growth prospects; where there's some new compelling territory to potentially dominate. One, maybe two, end up financially fattened along with lots who fail miserably trying.

A big part of the reason for Altria's long-term results was that the stock was often cheap. Over time, additional shares could be accumulated below per share intrinsic value through additional purchases, dividend reinvestments, and buybacks.

Now Altria's shares are currently somewhat more fully priced at 15-16x earnings. Not exceptionally expensive, but far too high to produce anything close to the compelling historic returns.
(That is, if the price to earnings were to mostly stay that high.)

So that mean forward long-term returns will be worse unless the stock gets cheaper and remains there long enough. I realize it's tough to convince someone to cheer when a truly cheap stock they just bought gets even cheaper. Yet it is, in fact, a good thing for the long-term owner. Obviously, it would be even better to buy the stock after it drops, but the point is if something was bought below intrinsic value in the first place -- and it proceeds to drop even further below intrinsic value -- the long-term investor should not really mind at all. Learning to ignore the annoying quotes isn't easy but it's also not impossible. Future purchases, dividend reinvestments, and buybacks will work to the long-term owners benefit. That's just how the math works. A long-term investor who buys shares of a good business at a fair or better price should view a further drop as a good thing.

It's also possible, of course, that the earnings multiple ends up going even go higher. Now, in the near-term, that higher multiple doesn't exactly seem like a terrible thing if it allows for a profitable sale, but keep in mind that something else attractive to buy must then be found.

Some taxes probably must also be paid on the gain.

That alone is tough to overcome. The exchange may work just fine, but it's easy to underestimate the possibility that, in the process, overall after-tax returns end up being reduced. Each move isn't just a chance to improve results; it's a chance to make misjudgments that reduce results.

My point is that the benefits of limiting activity are sometimes not fully appreciated. Once something sensible with attractive long-term prospects is bought at a good price, the threshold for making exchanges should be quite high.

In any case, this way of thinking will be of little relevance to those who actively trade stocks. Yet the logic and math behind this way of thinking should be very relevant for those with longer time horizons. For a comfortably financed business with sound economics, it is a drop in stock price -- or, at least a languishing stock price -- that will produce a much improved long-term result.

Over longer horizons, share prices roughly track per share intrinsic value. Over shorter horizons, that need not be the case.

Near-term (and even longer) anything can happen as far as price action goes.

This will work just fine as long as intrinsic value and how it will likely change over time -- within a range -- has been judged reasonably well.

It's when someone pays a price well in excess of value -- maybe on a speculative basis or due to misjudgment -- and it drops that there's a potential problem.

Permanent loss of capital.

What's somewhat bewildering is the fact that Altria's smokeable products volumes continue to shrink as they have for a very long time.

In general, domestic cigarette consumption has been in decline since the early 1980s.

I noted in the prior post that those who happen to buy Altria when the S&P 500 reached its pre-crisis peak on October 11th, 2007 -- hardly the ideal time -- actually experienced a very nice result.

In fact, Altria's annualized total return was roughly 17% since that peak.

Yet, since back in 2007, Altria's smokeable products volume declines have been anything but small.

Volume was 175.1 billion in 2007.

Last year it was 130.5 billion.

The number was more like 230 billion during the mid-1990s.

Despite these volume declines, Altria's equity returns -- mostly due to pricing power, high return on capital, and mostly low equity prices compared to intrinsic value -- ended up being roughly 17%. That's with the stock being purchased at the pre-crisis peak! Those returns are well above average, of course, and would naturally be improved with just slightly less inopportune purchases.

Altria does also have a solid smokeless products business and a valuable stake in SABMiller, but the vast majority of the company's value these days comes from a business that's in decline.

So exciting growth prospects can be one of the ingredients in an attractive investment.

It's just not a necessary ingredient.

"Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor." - Warren Buffett in his 1992 letter

Still, ideally the volumes wouldn't be declining so much.

Will the declines accelerate at some point?

Will it stabilize at some lower but still very lucrative level or not?

Will the environment around litigation, taxation, and regulation eventually change in a very negative and unforeseeable way?

These are tough things to figure out.

Taxation alone can have a big impact on volumes; these things interact.

I happen to NOT think Altria is such a wonderful investment if bought at or near current prices.***

Margin of safety matters with all investments. The price paid upfront is the best way to balance the investment specific risks against potential rewards.

Still, there's no need to own Altria's stock to learn something useful from it.

The current market valuation is a bit too high for my taste, but this doesn't mean I'll be selling my shares anytime soon. An attractive long-term investment, that's understandable (to the owner), and bought at a nice discount to value in the first place, shouldn't be sold just because it has become more fully valued. That's a recipe for making unnecessary mistakes.

My inclination is generally to not sell what I understand and have been fortunate enough to get at a good price. Increases to intrinsic value -- benefiting from long-term compounding effects -- should be the dominant factor in investing; clever trading in and out of positions should not. There's only so many things one investor can truly understand well. Those who think they can master many things are likely to end up operating outside of their comfort zone.

Still, inevitably, some selling ends up being warranted:

- when the stock price represents a significant premium to conservatively estimated per share value

- when prospects and core economics materially deteriorate (i.e. not just temporary but fixable difficulties)

- when prospects and core economics, in the context of the price initially paid, turn out to have been poorly judged

- when opportunity costs are high

A sound investment approach should be built upon thoughtful yet straightforward principles.

Additional complexity is sometimes necessary and warranted; more often it's not.

Simple, but not too simple, often works best.

It's a balance that isn't easy to figure out.

The right preparation in advance should enable decisive action when others are fearful.

Adam

Long position in MO established at much lower than recent prices. No intent to buy or sell near current prices.

Other related posts:
Aesop's Investment Axiom Revisited - Jul 2014
Altria: Timing Isn't Everything - Jul 2014
The Growth Trap: IBM vs Standard Oil - Jun 2014
Asset Growth and Stock Returns, Part II - Mar 2014
Asset Growth and Stock Returns - Feb 2014
Buffett and Munger on See's Candies, Part II - Jun 2013
Buffett and Munger on See's Candies - Jun 2013
Boring Stocks - Jun 2013
Aesop's Investment Axiom - Feb 2013
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
The Quality Enterprise, Part II - Aug 2012
The Quality Enterprise - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Consumer Staples: Long-term Performance, Part II - Dec 2011
Consumer Staples: Long-term Performance - Dec 2011
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Defensive Stocks Revisited - Mar 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Altria Outperforms...Again - Oct 2010
Altria vs Coca-Cola - Jul 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009
GM vs Philip Morris (Altria) - Apr 2009
Defensive Stocks? - Apr 2009

* As highlighted in the previous post, this effectively creates a mechanism for intrinsic value transfer. The ongoing purchases that are made at a discount to value -- whether incremental, dividend reinvestments, or buybacks -- benefit continuing long-term owners at the expense of those with a shorter horizon (that are willing to sell at a discount to value).
** Some might view e-cigarettes as a growth opportunity. I view it as a new risk for an investor even if it might turn out to be a very good thing for the world (if it reduces smoking). Even if the growth were to occur, there's no way to now judge whether it will be of the high return variety. Growth invites in new competition. The rules of the new e-cig game has many unknowns. Maybe it turns out to be wonderful for long-term shareholders; maybe not. I certainly have no way of usefully gauging such things.
*** It's worth mentioning that I certainly can understand why some won't own shares of Altria for non-economic reasons.
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