Unconventional wisdom: Learning from a top performing industry
Outperforming means swimming against the tide.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Learning from a top performing industry
Every great narrative is at least two narratives, if not more - the thing that is on the surface and then the things underneath which are invisible.
- Ali Smith
I’ve got two investment pitches for you. Before telling you what they are a brief description. This should be enough to decide if they are attractive investment opportunities.
First investment pitch
The companies in this industry sell consumer goods. The market for this product peaked in the early 1960s and has been declining ever since. Consumption has dropped 2% per year over the last 25 years.
The companies in this industry don’t market to existing or potential customers. This is not a choice. No marketing is allowed. In many places around the world the companies are required to pay to discourage using their products.
The products are taxed significantly and for many consumers the costs are prohibitive.
Ready to buy? Probably not. Let me try again with another sales pitch.
Second investment pitch
Every company that Morningstar covers in this industry has a wide moat. This means our analysts think the companies can sustain a competitive advantage for the next 20 years.
The companies have immense pricing power. Demand is relatively inelastic as brand loyalty is high and consumers are reluctant to consider competitors.
The industry is innovating and new products earn up to eight times the gross profit of the traditional product line. Based on the increasing uptake of the new products margins continue to expand.
Cash flow is robust and the free cash flow yield exceeds every other industry within the consumer defensive sector. This cash flow is mainly directed towards rewarding shareholders. Dividends are high and meaningfully exceed those of the overall market. There is a long history of dividend increases.
Does that investment pitch sound more attractive? It should. That description checks many of the boxes that investors are looking for.
You may have guessed that I’m describing the same industry. You may also have guessed I’m describing the tobacco industry.
What is so great about the tobacco industry?
Before you send me an angry email I’m not suggesting that you should buy tobacco shares. I know that many people find it morally repugnant to own a company that makes products that cause health problems. That is completely fair.
The point of this article is to explore why tobacco shares have performed so well, for so long, when the surface level industry narrative seems so negative. All investors can benefit from the lessons of the tobacco industry.
Just how well have tobacco shares performed?
I first came across tobacco stocks in my early 20s when I read Jeremy Siegel’s Stocks for the Long Run. In the latest edition of the book Siegel looks at the best performing share in the S&P 500 between 1925 and 2007. The winner is Phillip Morris.
Phillip Morris returned an average of 17% per year over 82 years. This happened despite smoking rates continually dropping in much of the world for over 60 years. This happened despite a definitive link being established between smoking and various forms of cancer and lung disease.
During this time smoking was banned in almost every public venue. Marketing cigarettes became illegal. Graphic warning labels were put on cigarette packs. Public health campaigns preached against smoking. In various countries tobacco companies were fined for misleading marketing. Taxes on tobacco were raised significantly.
The challenges in the tobacco industry did not occur in a vacuum. There were significant advancements in medicine, technology and transport. New companies and industries sprung up to harness and commercialise these advancements.
Yet there was Phillip Morris. Outperforming everything else. A $1000 investment in Phillip Morris in 1925 would be worth close to $1 billion today.
Defying the market narrative: The power of low expectations
Investors love narratives. Narratives are used to sell ETFs and funds. In some cases narratives nurture bubbles as collective delusion takes hold. In others, narratives induce formally rational investors to sell everything in a panic.
What separates an idea and a narrative is the degree of adoption. Once enough investors accept an idea it becomes a narrative that drives markets. Relying on a narrative means accepting conventional wisdom.
Most of the time conventional wisdom is right. Market prices represent the collective thinking of market participants. Many of these market participants are very smart and are paid a lot of money to try and exploit any mispricing. They are often right. That is why it is so hard to outperform the market.
The only way to beat the market is to find situations where the prevailing narrative is wrong. This is easy to do in retrospect. Not so easy in real time. One lesson from tobacco shares is the narrative was wrong for a very long time. Investor expectations were so low for the industry that outsized gains were the result of exceeding those expectations.
It isn’t hard to see why expectations were low. Many investors were able to quickly dismiss tobacco shares. Smoking levels kept dropping. There was a drumbeat of damning medical reports on the impact of smoking. Lawsuits mounted and regulations were tightened. There wasn’t a time when you weren’t inundated by negative headlines – for decades.
It was hard to see how tobacco companies could survive given this onslaught of bad news. The fact that they did and continued to be profitable was the secret to success. This is the power of low expectations. They aren’t that hard to exceed.
It is all about cash flows
What investors didn’t realise was some of the bad news had benefits for the tobacco companies. Not being able to do any marketing saved a lot of money. Given that smoking levels were dropping there was little need to invest in new capacity. This also saved money.
Much of the spending in any industry is based on the constant need to fend off rivals. This wasn’t much of an issue in the tobacco industry. The dismal prospects for the industry and the inability to market entrenched the established brands. There was little appetite for new competitors or much product innovation until lately.
On the revenue side things worked out ok despite the reduced levels of smoking. It turns out that selling an addictive product means significant pricing power. Below is an exhibit from a recent Morningstar report on the tobacco industry. Breaking down an income and cash flow statement for any share you own is helpful to illustrate the drivers that impact a company.
The challenges faced by the tobacco industry didn’t hurt their ability to generate cash and may have even helped. Altria (the former Phillip Morris) has raised their dividend for 57 years in a row.
Over the last 36 years the compounded annual growth rate of the dividend has been 6.46% which doesn’t include spinning off their holdings in Kraft or their international operations into a separate company.
Investors that have reinvested dividends have grown their income at a substantially higher rate as the shares have always had a high dividend yield because of low investor expectations.
Don’t forget that investing all comes down to the future cash flows a company can generate. Well run companies figure out the best way to use them to benefit shareholders. For some companies that means investing them at a high rate of return. For others it means returning them to shareholders.
Where do returns come from?
The returns I’ve outlined assumed that dividends were reinvested. Most returns you see make this assumption. Tobacco earnings grew because prices grew faster than volume declined. But earnings were not growing quickly.
The reason the returns were so high was because high dividends were reinvested at low valuations. In some cases those valuations were rock bottom when there were legitimate concerns the companies would go out of business. Add in a little earnings growth, small increases in valuation levels and you have a pathway for high returns.
Final thoughts
Tobacco companies benefited from low investor expectations, pricing power and the ability to generate lots of cash. This combination led to outsized returns for investors. This was a perfect storm and it isn’t easy to come up with an obvious parallel today.
The coal industry also has low expectations that seem to clash with how long the world will realistically need coal. There also seems to be little threat of competition and little need for capital expenditures given opposition to new mines. However, as a commodity coal doesn’t have the pricing power enjoyed by the tobacco industry. Oil & gas seems similar but with a longer runway of capital expenditures to expand production.
One industry that potentially has the most in common with tobacco is alcoholic beverages. Drinking is dropping in much of the western world. Small local brands are going out of business. The global giants have seen their share prices battered.
Yet companies like Diageo, Pernod Richard and Brown-Forman have wide moats due to brand loyalty and cost advantages. They are benefiting from consumers trading up to premium offerings even as volumes drop.
Thanks to the sell off Diageo, Pernod Richard and Brown-Forman are all trading in 5-star territory. Brown-Foreman is selling for less than 16 times cash flow. Diageo 12 and Pernod Richard 9.5. All have above market dividend yields while paying out less than 50% of earnings as dividends. Perhaps this is a case where the headline narrative is missing the underlying strength in the industry.
You can’t get different results if you don’t do something different. Investors never seem to remember that. Jumping on the bandwagon feels good because you are getting lots of validation. But that isn’t a way to outperform the market. It is likely you will get the timing wrong, pick the wrong company or do yourself in with trading costs and taxes.
If you want to outperform you better be prepared to swim against the tide.
Email me at [email protected] with your thoughts.
Shani and I have a favour to ask
Out book Invest Your Way was released on the 8th of October. A big thank you to everyone who ordered a copy in presale.
The book is also available on Kindle and the audiobook will be released on October 13th. We appreciate your continued support.
Invest Your Way is a personal finance book that combines foundational investing theory, real-world application and our own experiences. It is designed to help readers create a financial plan and investing strategy that is tailored to their unique goals and circumstances.
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What i’ve been eating
Some places it is better to eat locally than others. Hamilton Island falls in the good category. I spent the NSW long weekend on Hamiliton trying to eat as much reef fish as possible. Pictured is Cobia with artichoke and kaffir lime from the Pebble Beach restaurant. My favourite reef fish is Coral Trout which ironically was next on the tasting menu – unfortunately the official photographer for Unconventional wisdom had too many martinis to get a clear picture.
