Friday, July 11, 2014

Altria: Timing Isn't Everything

On October 11th, 2007, the S&P 500 reached its intraday pre-crisis peak.

The market as a whole certainly has been on a wild ride since then.

Now, let's consider a stock like Altria (MO).

It also had quite a ride since then -- I mean, few stocks were completely immune to the volatility -- even if it was somewhat less intense than the market as a whole.

Yet let's look at the overall results if Altria had been bought, rather unfortunately, at the peak on October 11th, 2007.

Well, those who purchased Altria's stock on October 11th and hung in there actually experienced a very nice result.

In fact, shares of Altria bought on that far from ideal date produced -- including the substantial reinvested dividends -- an annualized total return of roughly 17%.*

At that rate of return, and over that time frame, the value would have increased to nearly 3x the original investment.

Not a bad result considering that the starting point was on what was a very inopportune day. Naturally, some additional buying as the crisis unfolded -- as the stock price was getting cheaper -- could have only improved the result.

Of course, Altria's stock wasn't going to be immune to the nasty market price action that arose during the financial crisis, but the increasingly cheap shares were an ally to the long-term oriented owner. In fact, it was beneficial to continuing shareholders even if -- other than dividend reinvestments and buybacks -- no incremental purchases were made as the shares became cheaper.

Additional purchases by a continuing shareholder, at the temporarily reduced prices, would naturally also have been beneficial.

The point is that the lower prices can be a benefit, through the wise use of a company's excess capital, even if the shareholder decides to NOT purchase incremental shares.
(A dividend, of course, is excess capital produced by the company that's distributed to the owners but, unlike excess capital used for buybacks, the decision to invest in more shares must be made by each individual shareholder.)

The key is that market prices became reduced but per share intrinsic value did not. That's a very good combination for long-term owners. It is a permanent and substantial drop in per share intrinsic value that creates a real problem for investors.

More on this in a bit.

First, some context is in order.

Altria produced a 19.88% annual return (incl. reinvested dividends) over a roughly fifty year period that ended in 2006.

A 19.88% return over such a time horizon will turn a $ 10,000 initial investment into over $ 80 million.

The stock, including the impact of reinvested dividends, has -- much like what happened since October 2007 though not surprisingly somewhat better -- more than tripled since the end of 2006.

So that would put the tally on the initial $ 10,000 investment at something close to ~ $ 280 million. The power of compounding and a long time horizon.

There are, in my view, reasons why future results likely won't be nearly as favorable for Altria. Some of this comes down to whether the shares will again sell at a low earnings multiple. As it stands now, that's not the case. The stock often has sold at a low multiple over the decades and that had a lot to do with the investment outcome.
(While I intend to remain a long-term Altria shareholder, additional shares in the company are of little to no interest near current prices.)

Still, lots of useful investment lessons can be learned from Altria -- some of them counterintuitive -- then applied elsewhere if the opportunity arises.

Even if the stock itself happens to be of little interest, it can serve as a useful investment case study.

At least that is my view.

Some will argue, maybe correctly, that eventually all the things working against Altria (legal and regulatory risks, taxation, volume declines etc.) are finally going to catch up with the company and its investors.

It's also possible, however, that many of the inherent business strengths continue to at least mostly be there.

Now, lets get back to market prices, intrinsic values, and the implications for long-term investors. A big part of the explanation for Altria's high returns over the decades is that the stock was often rather cheap (price < intrinsic value). That resulted in per share intrinsic value growing faster than the overall intrinsic business value. How? Well, in effect, the less patient -- shorter term oriented -- owners and traders were transferring a portion of the per share intrinsic value to continuing owners over time. This intrinsic value transfer happened because they were consistently selling their shares at a discount to value. This meant, over time, that additional shares could be accumulated below -- maybe even far below -- per share intrinsic value through corporate buyback activity as well as dividend reinvestments.
(Buybacks can make sense when both more than sufficient funds are available to meet all operational/liquidity needs of a business AND the stock is cheap. The decision to pay a dividend -- by the board/management -- should come down to whether the business needs are covered while the decision to reinvest that dividend -- by the investor -- should be based on whether shares sell at a discount to value.)

Well, that transferred value doesn't just disappear, it ends up in the hands of continuing owners, and boosts total return.

Again, as noted above, the long-term investor in Altria could also decide from time to time to accumulate additional shares whenever they became cheap and it made sense in the context of the overall portfolio.

Yet, lacking incremental purchases, the dividend reinvestments and buybacks alone can benefit the long-term oriented owner greatly if the stock often sells nicely below per share intrinsic value.

This is how per share performance can exceed business performance, and sometimes to a substantial degree. Altria's businesses did just fine; its shares did even better.

The compounded effect is not at all a small one. It does allow per share intrinsic business value to outrun overall intrinsic business value. The power of this dynamic is, at least at times, more than a little underappreciated. It at least begins to explain the gap that can exist between business performance and stock price performance.

So, for long-term owners, the low prices that came about as a result of the financial crisis were a very good thing. Returns since 2007 were enhanced greatly by that drop in the stock price. This is why the price declines were actually an "ally" to those in it for the long haul. At the very least, something to consider the next time a sound long-term investment goes up in price in the near-term (or even intermediate-term).

Most end up feeling pretty good when they see their stock going up.

That's actually not the logical reaction unless one is, in fact, selling soon.

Unfortunately, Altria's shares are much more fully priced these days. If this situation were to persist going forward -- or worse, become priced even more highly relative to per share intrinsic business value -- it would lead to, all else equal, reduced future returns.

It's understandably tough to convince traders to think this way.

It should be easier to convince those with much longer time horizons but, well, it's just not.

Beyond the often low stock price relative to earnings power (and intrinsic value), these high equity returns also came down to the company's historic competitive advantages, and attractive core economics, across many of its businesses.
(Which, of course, once included food products and international tobacco products.)

These advantages contributed to pricing power and high returns on capital.

That pricing power, at least up to now, has generally made up for long-standing volume declines in Altria's core smokeable products business.**

Volume declines that have been substantial since 2007 alone, and, well, are generally expected to continue. For Altria in its current form, only U.S. volumes have been relevant since the Philip Morris International (PM) spin-off.

In any case, exciting growth is mostly not at all behind these results; it's just not a big part of the story.

Quite the opposite.

The question is whether Altria still possesses inherent advantages that will mostly persist going forward. The volume declines likely aren't going away anytime soon. The company -- other than the SABMiller (SBMRY) stake -- no longer has meaningful exposure to international markets. At some point will these things hurt investors? Will technology (e-cigarettes) change the competitive landscape and, more importantly, the business economics? A new technology can be an opportunity but doesn't only offer economic upside. Fundamental change can just as easily cut the other way; it can upset what had previously been excellent and sustainable business economics. So the future could offer a very different set of circumstances for Altria. As with any investment these kind of things must be considered. Of course, the future need not be quite as favorable as the past for the risk versus reward to still make sense.

At least if the price is right; if the value can still be estimated within a narrow enough range; if, going forward, the stock often sells at a discount to value so continuing owners can benefit from the intrinsic value transfer.

Altria's long-term past performance promises nothing about the future, of course. Still, the dynamics and factors that created the outcome, at the very least, seem well worth understanding.

So the assumption that growth is a required ingredient for high returns just isn't correct. For investors, this mistaken assumption can be costly.

How could growth not be a good thing? Well, sometimes growth is a very good thing. It's just not always a good thing.

Some seem to assume that all growth is of the high return variety.

Some seem to assume that the only road to high returns comes in the form of high growth.

Neither assumption is necessarily correct.

It's also clearly not about the timing; it's about how price compares to well-judged value, and how that value is likely to change -- considering the specific risks -- over the longer run; it's about identifying businesses that can maintain attractive core economics.

In other words, getting the price versus value judgment mostly right is difficult enough. Attempting to also time things consistently well can lead to unnecessary mistakes. The addition of timing to the equation is a distraction that's easy to do mostly in theory. Even if there surely are exceptions, it seems that more talk (or write) about timing things well than actually get results this way. Well, building an approach based upon the exception seems hardly wise. I'm guessing some who tried to cleverly time things -- who were given many chances to own sensible things at big discounts -- might now be having a rather difficult time finding stocks to buy. In fact, they may now be chasing things that are no longer selling with a sufficient margin of safety (or worse).

At a minimum, some skepticism is more than a little warranted when it comes to those who claim they can time things in a consistently effective way.

On the other hand, it is possible to turn the market dynamics -- sometimes driven by cognitive and emotional factors but barely related to economic value -- that tend to move prices near-term into an advantage. When something that was already cheap gets temporarily even cheaper this is hardly a disaster. The same goes for something originally bought cheap that goes to the other extreme.

Otherwise, better to ignore the near-term noise.

More in a follow-up.

Adam

Long positions in MO and PM established at much lower than recent market prices. As noted above, no intent to buy or sell near current prices. 

Other related posts:
Altria: Timing Isn't Everything, Part II - Jul 2014 (follow-up)
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 - February 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

* The Philip Morris International (PM) spin-off needs to be accounted for the get the return calculation correct. In other words, actual returns would naturally depend on whether or not the Philip Morris International shares were sold after the spin-off. It actually did work out somewhat better so far -- excluding tax implications -- if Philip Morris International shares had been sold and the proceeds were used to buy more Altria shares. Yet, either way, the investment outcome worked out just fine. Also, the two stocks have different risks that have to be considered. Keep in mind that these return numbers don't account for tax considerations.
** Smokeable products is the biggest driver of value for Altria in its current form. Smokeless products and the SABMiller (SBMRY) stake also make meaningful contributions to value. Wine is a very small contributor. Before the Kraft and Philip Morris International spin-offs, food products and international tobacco products were once a big part of the story.
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