Tuesday, June 2, 2015

Altria: Price Matters

This article, written by Morgan Housel earlier this year, notes that $ 1 invested in Altria (MO) back in 1968 would be, with dividends, worth $ 6,638 (Source: S&P Capital IQ).

That's a 20.6% annualized return.

That same dollar in the S&P 500 would be worth more like $ 87.

Now, consider Altria's stock performance over a somewhat different nearly fifty year time horizon; it's, in a similar way, not exactly unimpressive.

In fact, here's what one dollar invested from 1900-2010 became worth for American industry overall compared to tobacco companies (Source: Credit Suisse):

Average American Industry: $ 38k
Tobacco Companies: $ 6.3 million

Food companies also did rather well compared to the average stock but certainly couldn't match tobacco's performance.

Housel's article points out that "what's extraordinary about this story is that the cigarette industry has been in decline for decades."

U.S. cigarette volumes have, in fact, been in decline since the early 1980s. Those who assume that only through the ownership of businesses with exceptional growth prospects can exceptional returns be produced might want to take a closer look at this.

Housel points out that cigarette volumes hit their peak at 640 billion in 1981 and fell to 360 billion in 2007. Smoking rates have been falling for a very long time and seem likely to continue.

In 2014, 264 billion cigarettes were sold. So the volumes continue to drop.

That's the industry as a whole. What about Altria?

Well, Altria's smokeable products volumes continue to shrink as they have for a very long time.

Last summer, I pointed out that even someone who bought 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% for those who bought at the pre-crisis peak through July 2014.*

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 volume was 126.7 billion.

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

Over the years, I've covered Altria quite a bit, mostly because my view is there's much to be learned from it, even if someone has no interest in owning shares of the company.**

One of the reasons for the high returns relates to the company's historic competitive position and advantages. It's partly about established brands, strong distribution, and the lack of new competitors. It's the fact that small amounts of incremental capital is required to maintain what remains a wide moat. New competition (and fresh capital) doesn't usually chase markets that are getting smaller especially when established competitors exist. The existing rules are such that building a new tobacco brand is, if not impossible, a hugely difficult task.

Tobacco marketing restrictions make it tough for a new industry entrant to build an alternative brand. These restrictions tend to hurt the established brands less (or may even be a net benefit since, I think it's fair to say, it's much tougher to build a new brand than it is to fortify/enhance an existing one).

These built in advantages contribute to pricing power -- and high returns on capital -- even if litigation, regulation, and taxation remain, as they have for a very long time, unpredictable risks.

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

Will that continue? It has been and remains a key question.

Another one of the reasons Altria has worked so well over the long haul comes down to that the shares have been frequently cheap (i.e. selling at a nice discount to per share intrinsic value). The benefits of a stock remaining cheap over an extended time shouldn't be underestimated in the context of managing risk and reward. What happens when a stock remains persistently cheap is, in effect, that an intrinsic value transfer occurs from short-term oriented owners to the longer term continuing owners through buybacks and 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.)

Of course, incremental purchases would also be beneficial. In all cases, whether buybacks, dividend reinvestments, or incremental purchases, these actions only make sense when shares sell for less than intrinsic worth. (Naturally, paying a premium to value benefits the seller.) The transfer of intrinsic value comes from the gap between price paid and per share value. The compounded effect over many years can end up being not at all small.

Yet the key is there's no need for the shareholder to purchase incremental shares to benefit. The buybacks and dividend reinvestments alone -- as long as shares are only bought at a plain discount -- can make a big difference in terms of total return.

Well, these days, Altria's stock is no longer selling at a meaningful discount to intrinsic value (especially compared to some of my earlier posts). It's gone from a single digit multiple of earnings to a high teens multiple of earnings. Return expectations, as a result, must necessarily become much reduced. That doesn't necessarily make it an awful investment, but does meaningfully alter the risks versus potential rewards.

As always, history isn't what matters; what happens going forward does. Altria now sells at a rather more full valuation. Other tobacco stocks seem, at least to me, also fully valued if not expensive. So one of the key factors behind the long-term stock performance -- frequently selling at a nice discount to value -- has been, at least for now, mostly eliminated.

Those expecting Altria's stock to produce the kind of results it has in the past -- at least from current valuation levels and especially if the future earnings multiple remains persistently high -- seem likely to be very disappointed. Now, even more speculative prices could temporarily emerge. Such a situation would benefit those who are selling in the short run but would only end up hurting the long-term owner (at least those, despite the price increases, who'd still prefer not to be selling). It also might create pressure to sell what's well understood with solid long-term prospects in order to buy something else (that might be less well understood but now appears more reasonably valued).

While selling an asset at a full (or more than full) price may not exactly be an unsatisfactory outcome (it certainly beats selling at a loss), it does potentially lead to unnecessary mistakes and added frictional costs. The risk-reward of the less well understood investment alternatives may be misjudged. That's more likely to happen when trading what you've developed a good understanding of for something where that's less the case. With reduced conviction levels, it might be tougher to hang in there when the inevitable business difficulties emerge. Even the best businesses eventually end up facing some real challenges. Also, viable alternatives offering plainly superior forward returns, all costs and risks considered, may not be available when needed.

Patience required. Otherwise, avoidable errors get made.

It's easy to end up owning what's outside one's own circle of competence -- something that's necessarily unique for each investor -- when there's pressure to find an investment that's more attractive than the (well understood) investment just sold.

Each portfolio move isn't just a chance to improve results; it's also a chance to subtract from results. It's easy to overemphasize the former while not sufficiently considering the latter.

There's usually few complaint when shares of a long-term investment heads higher but, in fact, that rally can make the job of the investor more difficult (i.e. inherently more susceptible to error) over the longer haul.

In other words, those who like Altria -- or maybe some other favored business -- for the long-term would benefit greatly if its stock price did poorly over the next several years or, better yet, dropped substantially from current levels to well below intrinsic value.

I realize that's a tough sell for traders; it shouldn't be for long-term owners.

This, at times, requires the kind of temperament that can ignore temporary paper losses. Easier to do if the confidence in estimated intrinsic value -- and how that value will change over time -- is warranted.

Buying favored shares consistently at a discount -- whether via buybacks, dividend reinvestments, and incremental purchases -- has the potential to reduce errors. Sometimes, being forced outside of one's comfort zone leads to unnecessary and costly mistakes. Those who stick to owning only what they know (i.e. what's likely to be valued correctly and where confidence is warranted) make misjudgments, at the very least, somewhat less likely.

For obvious reasons, considering the products they sell, tobacco businesses will not be seen by some as a viable investment. I certainly don't blame anyone who will not invest for that reason alone.

Still, there are plenty of lessons to be learned from Altria that can be applied elsewhere.

A sound long-term investment, that's understandable (to the owner), and bought at a nice discount to value in the first place, shouldn't necessarily be sold just because it has become more fully valued.***

To me, that's a recipe for making unnecessary mistakes.


It simply means the risk versus reward has changed substantially and, especially if the price appreciation were to persist well in excess of increases to per share intrinsic value, the capital might reluctantly even become a candidate for something else more attractive.


Opportunity costs.

At a minimum, it's understandable if a business that's serving a market in decline doesn't feel like a great investment (and, going forward, that may ultimately prove to be the case).

It's just important to remember that -- for investors -- what intuitively feels correct can be very different from what is, if not a perfect solution, more correct than not and far more useful.
(Or, at least, what's the best answer is very different from what intuitively feels like the best answer.)

Sometimes, what doesn't quite fit expectations deserves the most attention.

"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

Counterintuitive. Paradoxical. Contradictory. Inconsistent.

At times, that's where the best insights reside.

As always, I have no opinion on what the price of any stock might do in the near-term or even much longer. I just try to appreciate how much that lower prices can, under the right circumstances, be a very good thing for the long-term owner, knowing it can also be less than intuitive especially when viewed over the shorter run.

####
None of the above begins to deal with the difficult question of the right amount of diversification. Naturally, sufficient diversification needs to be considered carefully with the right answer being very much specific to the investor.

Some investors need a bunch of it; others might not.

Yet, under the guise of diversification, sometimes an investor will end up investing in areas rather far removed from their core knowledge and capabilities. The situation noted above -- where a high valuation pushes the investor out of a sound investment into something else they don't understand -- is just one example of why this might happen. Well, whatever might be the appropriate diversification for a particular investor, it's hard to imagine why going from what truly is within someone's comfort zone into uncharted territory could be viewed as beneficial diversification. Their are limits to what any one investor can get their arms around.

There are many fine businesses I should never consider owning (even if they appear inexpensive) for the simple reason that the requisite knowledge, experience, and ability to analyze is lacking on my part.

Not all diversification is wonderful.

Invest in what you know.

It'd be different if the investment process offered a nearly endless supply of sound and sufficiently understood alternatives.

It generally does not.

Adam

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

Related posts:
Multiple Expansion, Buybacks, & The P/E Illusion
The P/E Illusion
The Benefits of a Declining Stock
Altria: Timing Isn't Everything, Part II
Altria: Timing Isn't Everything
Buffett's Purchase of IBM Revisited
Buffett on Buybacks, Book Value, and Intrinsic Value
Buffett on Teledyne's Henry Singleton
Why Buffett Wants IBM's Shares "To Languish"
Buffett: When it's Advisable for a Company to Repurchase Shares
The Best Use of Corporate Cash
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Altria Outperforms...Again
Altria vs Coca-Cola
Buy a Stock...Hope the Price Drops?
GM vs Philip Morris (Altria)

* The stock is up an additional ~ 20% (incl. dividends) since that was written. That's unfortunate because buybacks and dividend reinvestments combined with a stock often selling well below intrinsic value has historically provided an incredible tailwind for long-term owners. Well, such a tailwind really isn't there near current prices. A drop in price would be welcome at this point. Speculators want price action to go in a particular direction as soon, and as much, as possible. Certainly nothing wrong with that. Investors focus on - or, at least, generally focus on -- whether the excess cash produced on a per share basis is increasing at a satisfactory long-term rate with consideration for the specific risks and the price paid. The former emphasizes price action; the latter emphasizes what's being produced by the business over time. There's naturally some overlap (or a grey area) between speculation and investment -- and others might have different definitions -- but the differences in emphasis still matter.
** Some excerpts from a few of my previous Altria posts.
In 2009 I wrote:
A big part of the returns produced by Philip Morris/Altria came from dividends that were reinvested in a stock that was consistently inexpensive (this works in a similar way to share buybacks other than tax considerations). The fact that some investors won't touch a tobacco stock along with the risk of litigation, regulation, taxation, and declining volumes kept shares of Philip Morris/Altria mostly cheap for many years.

In 2010 I wrote:
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 (though, depending on the circumstances, this is generally more tax efficient). 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.

In 2014 I wrote:
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.


AND

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.
*** 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
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