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
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Showing posts with label Consumer Goods. Show all posts
Showing posts with label Consumer Goods. Show all posts
Tuesday, June 2, 2015
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.
----
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
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.
----
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
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.
----
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
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.
----
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Friday, October 18, 2013
Best Global Brands 2013
According to a report by Interbrand released late last month, Apple (AAPL) is now the most valuable global brand.
Coca-Cola (KO) had held the top spot for 13 straight years in prior Interbrand reports.
It now sits at number 3.
Top Ten Most Valuable Global Brands
1 Apple
2 Google (GOOG)
3 Coca-Cola
4 IBM (IBM)
5 Microsoft (MSFT)
6 General Electric (GE)
7 McDonald's (MCD)
8 Samsung (SSNLF)
9 Marlboro (INTC)
10 Toyota (TM)
Website: Best Global Brands 2013
Press Release: Interbrand's 14th Annual Best Global Brands Report
Report: Best Global Brands 2013
This top ten ranking of global brands has some similarities to the entirely separate ranking of global brands released earlier this year by Millward Brown.
Apple, Google, Coca-Cola, IBM, Microsoft, and McDonald's make the top ten on both lists. The specific value these two rankings place on each brand is in some cases, not surprisingly, very different (e.g. the study earlier this year puts Apple's brand value at $ 185 billion, the newer ranking places it at more like $ 98 billion).
Some of the are differences between the two rankings will naturally come down to methodology.
Interbrand's methodology is explained here. For inclusion in their rankings, a brand needs to have a "truly global" presence as defined by their methodology.
"In measurable terms, this requires that:
- At least 30 percent of revenues must come from outside the brand's home region
- It must have a presence in at least three major continents, as well as broad geographic coverage in emerging markets
- There must be sufficient publicly available data on the brand's financial performance
- Economic profit must be expected to be positive over the longer term, delivering a return above the brand’s operating and financing costs
- The brand must have a public profile and awareness above and beyond its own marketplace.
These requirements...lead to the exclusion of some well-known brands that might otherwise be expected to appear in the ranking. The Mars and BBC brands, for example, are privately held and do not have publicly available financial data. Walmart, although it does business in international markets, often does so under a variety of brands and, therefore, does not meet Interbrand's global requirements.
For similar reasons, brands in several sectors have been excluded."
These are:
Telecommunications - strong ties to their national markets but "awareness challenges" further away from home.
Airline industry - capital intensiveness and low margins result in brands that "struggle to achieve positive economic profits over the long term."
Pharmaceutical companies - consumer relationship is generally with the product brands (more so than the corporate brand owner) and "insufficient publicly disclosed financial data on pharmaceutical product brands."
Top 100 Global Brands
Among the top 100, Nokia's (NOK) brand, took the biggest hit in both absolute and percentage terms. Not exactly a surprise.
Google was the biggest gainer in absolute terms.
Facebook (FB) was the biggest gainer in percentage terms.
To me, it seems rather unlikely that brand value could ever be pinned down -- and I mentioned this in the post on Millward Brown's rankings -- as precisely as might be implied by these rankings.
Still, these studies are provide some indication which brands matter around the world and how -- in at least a rough sense -- their value might be changing.
Adam
Established long positions in AAPL, GOOG, KO, MSFT, and GE at much lower than recent prices. Recently added small new IBM position.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Coca-Cola (KO) had held the top spot for 13 straight years in prior Interbrand reports.
It now sits at number 3.
Top Ten Most Valuable Global Brands
1 Apple
2 Google (GOOG)
3 Coca-Cola
4 IBM (IBM)
5 Microsoft (MSFT)
6 General Electric (GE)
7 McDonald's (MCD)
8 Samsung (SSNLF)
9 Marlboro (INTC)
10 Toyota (TM)
Website: Best Global Brands 2013
Press Release: Interbrand's 14th Annual Best Global Brands Report
Report: Best Global Brands 2013
This top ten ranking of global brands has some similarities to the entirely separate ranking of global brands released earlier this year by Millward Brown.
Apple, Google, Coca-Cola, IBM, Microsoft, and McDonald's make the top ten on both lists. The specific value these two rankings place on each brand is in some cases, not surprisingly, very different (e.g. the study earlier this year puts Apple's brand value at $ 185 billion, the newer ranking places it at more like $ 98 billion).
Some of the are differences between the two rankings will naturally come down to methodology.
Interbrand's methodology is explained here. For inclusion in their rankings, a brand needs to have a "truly global" presence as defined by their methodology.
"In measurable terms, this requires that:
- At least 30 percent of revenues must come from outside the brand's home region
- It must have a presence in at least three major continents, as well as broad geographic coverage in emerging markets
- There must be sufficient publicly available data on the brand's financial performance
- Economic profit must be expected to be positive over the longer term, delivering a return above the brand’s operating and financing costs
- The brand must have a public profile and awareness above and beyond its own marketplace.
These requirements...lead to the exclusion of some well-known brands that might otherwise be expected to appear in the ranking. The Mars and BBC brands, for example, are privately held and do not have publicly available financial data. Walmart, although it does business in international markets, often does so under a variety of brands and, therefore, does not meet Interbrand's global requirements.
For similar reasons, brands in several sectors have been excluded."
These are:
Telecommunications - strong ties to their national markets but "awareness challenges" further away from home.
Airline industry - capital intensiveness and low margins result in brands that "struggle to achieve positive economic profits over the long term."
Pharmaceutical companies - consumer relationship is generally with the product brands (more so than the corporate brand owner) and "insufficient publicly disclosed financial data on pharmaceutical product brands."
Top 100 Global Brands
Among the top 100, Nokia's (NOK) brand, took the biggest hit in both absolute and percentage terms. Not exactly a surprise.
Google was the biggest gainer in absolute terms.
Facebook (FB) was the biggest gainer in percentage terms.
To me, it seems rather unlikely that brand value could ever be pinned down -- and I mentioned this in the post on Millward Brown's rankings -- as precisely as might be implied by these rankings.
Still, these studies are provide some indication which brands matter around the world and how -- in at least a rough sense -- their value might be changing.
Adam
Established long positions in AAPL, GOOG, KO, MSFT, and GE at much lower than recent prices. Recently added small new IBM position.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Wednesday, June 26, 2013
Buffett and Munger on See's Candies, Part II
A follow up to this post. Roughly two years ago, Charlie Munger said the following about what he and Warren Buffett learned from buying See's Candies:*
"When we bought See's Candies, we didn't know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning that changed Berkshire. It was really important.
You have to be a lifelong learner to appreciate this stuff. We think of it as a moral duty."
As always, the price paid relative to value -- paying a plain discount to conservative per share intrinsic value -- matters a whole lot when it comes to reducing risk while increasing potential reward for the long-term investor.** Otherwise, attractive risk-adjusted returns come from owning a business (or part of a business via marketable common stocks) with characteristics that lead to attractive and durable return on capital.
Well, it's having sustainable pricing power (and a commodity that's in high demand/in short supply doesn't qualify) that is often a key driver of return on capital. Possession of a great brand -- what Buffett calls "share of mind" -- can provide an ongoing source of sustainable pricing power.
(Even if, as in the case of See's, it happens to be primarily regional brand strength developed over many years.)
In the prior post I noted the following:
...if a business can raise price a certain percentage each year and it mostly sticks (i.e. there's no real hit to volume), the increase all falls to the bottom line after taxation. If that same business instead had a similar percentage increase in revenue via greater unit volume, there inevitably has to be an incremental cost -- sometimes significant -- associated with each additional unit. The result being -- at least when there's real pricing power -- not as much of an equivalent increase in revenue actually falls to the bottom line.***
A price increase requires no additional capital and has no incremental cost. What matters is whether price can be increased in a way that doesn't significantly impact volume. Here's what Warren Buffett said at the 2005 Berkshire Hathaway (BRKa) shareholder meeting:
"We like buying businesses with some untapped pricing power. When we bought See's for $25 million, I asked myself, 'If we raised prices by 10 cents per pound, would sales fall off a cliff?' The answer was obviously no. You can determine the strength of a business over time by the amount of agony they go through in raising prices."
In contrast, what it takes to support the added unit volume certainly creates additional operating costs and might even require more capital to be employed.
Either way, that means reduced return on capital for similar incremental growth.
Growth, in itself, can be an overrated. Well, at least it can be when it comes to generating attractive risk adjusted shareholder returns. At a minimum, there's a great tendency to overpay for it.
During this interview with the Financial Crisis Inquiry Commission (FCIC), Warren Buffett had the following to say about the importance of pricing power when evaluating a business:
It also helps if the business requires little in the way of capital to maintain or even strengthen its advantages.
See's may, in the very long run, attempt to expand beyond its mostly regional footprint (in fact, there's for the first time some at least limited indication they may) but that will make sense only if they can develop the "share of mind" where they move to next.
Some might wonder why they didn't expand sooner. That takes patience, time, and it's not inevitable that it will work. Enduring some pain in the near-term or longer, the willingness to forgo returns early on to gain a foothold -- what Tom Russo calls the "capacity to suffer" -- can make a lot of sense. Many of the great global consumer franchises do just that but it depends on the specific circumstances. When it comes to the "capacity to suffer", Russo also emphasizes the importance of first mover advantage. Well, one of the reasons See's may not want to move into a new region is the existence of already entrenched brands. The lack of first mover advantage could mean the returns on the incremental capital invested turn out to be unattractive.
The good news is that there's often nothing wrong with striving for more modest growth prospects while using the excess capital wisely elsewhere. That's essentially what Berkshire has been doing with See's for more than 40 years. It depends not just on first mover advantage but also on the competitive landscape more generally (and many other factors, of course).
Those that push for growth -- too often blindly in the context of the capital requirements -- sometimes underestimate this. Exciting growth prospects need to be fully understood in the context of the incremental capital investment. Will it actually be of the high return variety? Could that capital be put to use elsewhere at higher returns and less risk?
High return growth is not a given. Some treat all forms of growth as a good thing or, at least, assume the growth will be high return in nature.
From the 1992 Berkshire Hathaway shareholder letter:
"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive."
Remember, for example, that airlines grew for a long time at impressive rates. Saying the returns from all that capital investment have been poor for those who held common stock in airlines is more than an understatement.
(I'm writing strictly from a common shareholder perspective. Airlines and air travel clearly have been quite important and valuable to civilization in other ways.)
More from the 1992 Berkshire letter:
"...business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.
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."
Sometimes growth is pursued where lots of capital must be deployed -- with diminishing and even negative returns -- to continue fueling that growth.
In the short run (and sometimes even much longer), exciting growth can provide for equally exciting stock price action. That's fine, I suppose, if one likes to speculate on such things.
In the long run, investors will have quite a difficult time benefiting from behavior that amounts to growth for its own sake or growth for growth's sake.
Well, at least they will have difficulty benefiting on an intrinsic basis.
Some might decide to treat the See's example as nothing more than a merely interesting curiosity and consider its implications no further.
I happen to think that's a mistake.
To me, it's an essential business and investing lesson.
Adam
Long position in BRKb established at much lower than recent prices
Related posts:
Buffett and Munger on See's Candies - 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
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
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Buffett: What See's Taught Us - May 2011
Buffett on Coca-Cola, See's & Railroads - May 2011
Buffett on Pricing Power - Feb 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 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
Pricing Power - Jul 2009
The Growth Myth - Jun 2009
Buffett on Economic Goodwill - Apr 2009
* According to The Motley Fool these notes are "in Munger's own words, lightly edited and condensed for clarity."
** Note that the correlation between risk and reward need not be positively correlated.
*** Even if a modest drop in volume were to occur, the increased price may still make sense as far as total return goes. It all comes down to how much pricing power actually exists. What some might describe as being price inelastic.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
"When we bought See's Candies, we didn't know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning that changed Berkshire. It was really important.
You have to be a lifelong learner to appreciate this stuff. We think of it as a moral duty."
Buffett said something very similar in this more recent article:
"We have made a lot more money out of See's than shows from the earnings of See's, just by the fact that it's educated me, and I'm sure it's educated Charlie too."
"We have made a lot more money out of See's than shows from the earnings of See's, just by the fact that it's educated me, and I'm sure it's educated Charlie too."
As always, the price paid relative to value -- paying a plain discount to conservative per share intrinsic value -- matters a whole lot when it comes to reducing risk while increasing potential reward for the long-term investor.** Otherwise, attractive risk-adjusted returns come from owning a business (or part of a business via marketable common stocks) with characteristics that lead to attractive and durable return on capital.
Well, it's having sustainable pricing power (and a commodity that's in high demand/in short supply doesn't qualify) that is often a key driver of return on capital. Possession of a great brand -- what Buffett calls "share of mind" -- can provide an ongoing source of sustainable pricing power.
(Even if, as in the case of See's, it happens to be primarily regional brand strength developed over many years.)
In the prior post I noted the following:
...if a business can raise price a certain percentage each year and it mostly sticks (i.e. there's no real hit to volume), the increase all falls to the bottom line after taxation. If that same business instead had a similar percentage increase in revenue via greater unit volume, there inevitably has to be an incremental cost -- sometimes significant -- associated with each additional unit. The result being -- at least when there's real pricing power -- not as much of an equivalent increase in revenue actually falls to the bottom line.***
A price increase requires no additional capital and has no incremental cost. What matters is whether price can be increased in a way that doesn't significantly impact volume. Here's what Warren Buffett said at the 2005 Berkshire Hathaway (BRKa) shareholder meeting:
"We like buying businesses with some untapped pricing power. When we bought See's for $25 million, I asked myself, 'If we raised prices by 10 cents per pound, would sales fall off a cliff?' The answer was obviously no. You can determine the strength of a business over time by the amount of agony they go through in raising prices."
In contrast, what it takes to support the added unit volume certainly creates additional operating costs and might even require more capital to be employed.
Either way, that means reduced return on capital for similar incremental growth.
Growth, in itself, can be an overrated. Well, at least it can be when it comes to generating attractive risk adjusted shareholder returns. At a minimum, there's a great tendency to overpay for it.
During this interview with the Financial Crisis Inquiry Commission (FCIC), Warren Buffett had the following to say about the importance of pricing power when evaluating a business:
"...the single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you've got a terrible business."
It also helps if the business requires little in the way of capital to maintain or even strengthen its advantages.
See's may, in the very long run, attempt to expand beyond its mostly regional footprint (in fact, there's for the first time some at least limited indication they may) but that will make sense only if they can develop the "share of mind" where they move to next.
Some might wonder why they didn't expand sooner. That takes patience, time, and it's not inevitable that it will work. Enduring some pain in the near-term or longer, the willingness to forgo returns early on to gain a foothold -- what Tom Russo calls the "capacity to suffer" -- can make a lot of sense. Many of the great global consumer franchises do just that but it depends on the specific circumstances. When it comes to the "capacity to suffer", Russo also emphasizes the importance of first mover advantage. Well, one of the reasons See's may not want to move into a new region is the existence of already entrenched brands. The lack of first mover advantage could mean the returns on the incremental capital invested turn out to be unattractive.
The good news is that there's often nothing wrong with striving for more modest growth prospects while using the excess capital wisely elsewhere. That's essentially what Berkshire has been doing with See's for more than 40 years. It depends not just on first mover advantage but also on the competitive landscape more generally (and many other factors, of course).
Those that push for growth -- too often blindly in the context of the capital requirements -- sometimes underestimate this. Exciting growth prospects need to be fully understood in the context of the incremental capital investment. Will it actually be of the high return variety? Could that capital be put to use elsewhere at higher returns and less risk?
High return growth is not a given. Some treat all forms of growth as a good thing or, at least, assume the growth will be high return in nature.
From the 1992 Berkshire Hathaway shareholder letter:
"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive."
Remember, for example, that airlines grew for a long time at impressive rates. Saying the returns from all that capital investment have been poor for those who held common stock in airlines is more than an understatement.
(I'm writing strictly from a common shareholder perspective. Airlines and air travel clearly have been quite important and valuable to civilization in other ways.)
More from the 1992 Berkshire letter:
"...business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.
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."
Sometimes growth is pursued where lots of capital must be deployed -- with diminishing and even negative returns -- to continue fueling that growth.
In the short run (and sometimes even much longer), exciting growth can provide for equally exciting stock price action. That's fine, I suppose, if one likes to speculate on such things.
In the long run, investors will have quite a difficult time benefiting from behavior that amounts to growth for its own sake or growth for growth's sake.
Well, at least they will have difficulty benefiting on an intrinsic basis.
Some might decide to treat the See's example as nothing more than a merely interesting curiosity and consider its implications no further.
I happen to think that's a mistake.
To me, it's an essential business and investing lesson.
Adam
Long position in BRKb established at much lower than recent prices
Related posts:
Buffett and Munger on See's Candies - 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
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
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Buffett: What See's Taught Us - May 2011
Buffett on Coca-Cola, See's & Railroads - May 2011
Buffett on Pricing Power - Feb 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 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
Pricing Power - Jul 2009
The Growth Myth - Jun 2009
Buffett on Economic Goodwill - Apr 2009
* According to The Motley Fool these notes are "in Munger's own words, lightly edited and condensed for clarity."
** Note that the correlation between risk and reward need not be positively correlated.
*** Even if a modest drop in volume were to occur, the increased price may still make sense as far as total return goes. It all comes down to how much pricing power actually exists. What some might describe as being price inelastic.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.
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