At least in the developed world, more and more people either stop smoking or never begin in the first place. The (relative) number of people smoking traditional cigarettes declines as it goes against the big secular health trend. Could this current situation set the stage for profitalbe investments for many years?
This is not investment advice. Please read the disclaimer.
Did you know?
You could have earned a fortune with a tobacco stock. Altria (MO US), one of the mayor tobacco stocks, delivered a total return of 62,000% over the last 40 years, turning a $10,000 investment made on 3rd August 1980 into 6.2 million USD today (3rd Aug, 2020). Expecting such a return from a tobacco investment initiated today is probably a bit too high, but, it shows extraordinary returns are possible with tobacco stocks. Why is that?
In general, consumers aren’t too obsessive about cheap prices (they smoke for a reason) and they are rather loyal, sticking to their preferred brand. These factors allow for high operating margins. Brands were build by big marketing budgets. Since nowadays many countries ban certain kinds of tobacco commercials market shares are rather constant and capital expenditure capex is minimal, resulting in big dividend payouts for shareholders.
Since investing is a popularity contest, the potentially most profitable investments are to be found in the pile of stocks currently the least popular as recently written in my post Going to the most fertile hunting grounds. Nowadays, many investors shun tobacco stocks for ESG reasons and a less than stellar fundamental outlook based on declining smokers.
Industry
Major tobacoo companies include British American Tobacco (BATS LN), Phillip Morris International (PM US), Altria (MO US, spun of from PM), Japan Tobacco (2914 JT), Imperial Brnads (IMB LN). The stocks of these companies offer compelling dividend yields in the high digits or even low teens range, since they generate high margin earnings or lots of cash from operations (CFFO) and they just do not have better opportunities to deploy all that cash (low reinvestment needs). In recent years, these companies invested some cash (speaking about billions of USD) in alternative product companies, though …
- Dec 2018: Altria Makes $12.8 bn Investment in JUUL to Accelerate Harm Reduction and Drive Growth (followed by impairments)
| M Cap | EV | P/E | DIV | TXT | |
|---|---|---|---|---|---|
| MO | 77 | 100 | 10x | 8.3% | US, high returns, iqos license |
| PM | 130 | 155 | 15x | 5.8% | international, growth, iqos |
| 2914 | 40 | 45 | 12x | 7.5% | JP, Asia, low growth |
| IMB | 21 | 35 | 8.5x | 8.5% | high leverage, menthol issue |
Smaller more exotic tobacco companies can be found in emerging or developing countries (and here) with even lower valuations. Examples are Carreras (CAR JA) with a 9x P/E, Easter Co (EAST EY, 8x), British American Tobacco Kenya (BATK, 13x), Ceylon Tobacco (CTC SL, 12x), Philip Morris CR (TABAK CP, 10x).
Shrinking Markets
We learned that smoking is pretty much out of style in the (mainstream) media and that there are less and less people smoking. But is that true? The answer is it depends (as so often in life). It depends on geography (developed or developing countries) and on the exact metric (total smokers or smoking rate).
There are relatively less people who smoke. That is true for almost all countries, but huge differences between countries persist. Today, there are only a few small countries left, where the share of smoking people aged 15 and older is above 40% (read here).
The total number of global smokers is about 1 bn. More smokers live in China than in any other country (see here). But the Chinese market is very much state controlled (for a good reason I believe).
I used to smoke a few year ago on weekends when having a beer. But I did not smoke for many years. Nowadays I dislike smoking and I hate it when many people smoke next to me, which happens when meeting privately for a drink – and I admit to attribute the better share of my hangovers (few and far between) to the passive smoking. Even worse, I change sidewalks occasionally when a smoker walks infront of me 😉
Much of the shrinkage in units sold (traditional cigerettes volumes) was made up for by price increases, resulting in better total sales trends as one would basically assume. The big question is, how long can these trends (rising total sales on less volumes sold at ever higher prices) persist.
Three thoughts
The good about tobacco investments is they are very provitable. New entrants are not to be seens and market shares are cemented by regulation (some forms of marketing are forbidden). Additionally their (historic) product is non-cyclical and consumers are hooked, mostly taking part in price-increases. Since there are or were simply no reinvestment needs / opportunitites all their cashflow went into shareholder returns via dividends and buybacks, thus capital is not wasted in unprofitable endeavors. Further, it is an industry shun by many investors due to some ESG criteria.
The bad these criteria are somehow true. Tobacco is just not a win-win-win product. It is mostly bad for consumers, though, you can say that about a lot of products (beer, fast cars, (un)social media, …). Taxes could rise further, with negative effects for the bottom lines likely being mostly mitigated by price increases (that strategy has worked well so far). But at some point people will smoke muss less probably and units sold could crash. As an individual private investor, dividend income is taxed: Since high dividend paying tobacco companies are clearly not ‘Hiding from the tax man‘ my (and probably your) realized after-tax returns will be much lower than gross returns.
The unknowns are manyfold. Who knows how regulation will tackle this industry in various countries? Who knows how alternative products and ‘reduced-risk’ markets will evolve over time? Will they bring new competition? Getting a firm view on the companies’ fundamentals is not easy. How will their business look like in 10, 20 years?
- PM probably has the best long-term outlook, but
- offers the lowest yields (for a reason) …
During a market-sell off tobacoo majors could be the companies easiest to buy with non-cyclical products and high shareholder-returns.
Further readings
Terry Smith on Investing in Tobacco Stocks – Dividend Growth Investor
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