Investing In Hated and Evil Sectors
When you think about the biggest winners in the stock market, I'll willingly wager that you are immediately drawn to companies that have changed the world. You know, the highly innovative game changers that have altered the way we live.
I know my mind immediately goes to businesses like Google, Apple, CSL, I hate to admit it but Tesla is deserving of a place here, Microsoft, Amazon, the list goes on and on. I'll let you think about the hundred other stocks that have changed the world and rewarded shareholders immensely.
However, recently I read a study by Credit Suisse that studied the performance of every industry in the US from 1900 - 2010. Apparently, $1 invested in the average industry grew to a value of $38,255. However, there was one standout that blew my mind.
Tobacco stocks would have returned $6,300,000 from a single dollar.
I wouldn't have been surprised if Tobacco was the top industry if the study ended in the 50's, 60's or even 70's but in a period that ended so recently. I'm a lover of old movies and you can't watch a movie from that time period without seeing the hero's, villains, and even the background extra's with a dart in their hand almost continuously.
But surely, in the later years of this study these stocks would have been destroyed? Let's look at the headwinds:
Unless you have lived on Mars for the last 40 years, it's considered standard knowledge that smoking kills.
Tobacco companies have been sued to the hilt. I doubt my calculator screen is big enough to include just how many dollars they have been sued for and have paid out.
Smoking volume has been declining consistently for decades.
There has been huge advertising bans on cigarettes for longer than I've been alive.
As a result of the first point, and the anti tobacco lobby, the taxes and prices for cigarettes are increasing at an astronomical pace.
On the surface we have an industry that has declining volumes (with laws in New Zealand for example have banned people born after 2008 from buying cigarettes) with the strong likelihood of hitting zero at some point in the future, an industry that's been sued to kingdom come, in Australia we don't just have plain packaging but graphic pictures of the damage smoking causes on each pack, no advertising and an entire industry designed to shut tobacco down. Not exactly a recipe for great success.
Thinking back to the Credit Suisse study, all the returns must have come in the good old days and the most recent part of the study surely has been terrible for the industry?
Well, I recently read that from 1988 until 2018, $100,000 invested in Phillip Morris (assuming no dividend reinvestment) would have grown to a tick over $18,000,000. For comparison, in the that time Apple has changed the world via the Mac, iPod, iPhone, iPad etc. The same $100,000 invested in Apple would have grown to a tick under $14,000,000. (note I didn't do this research and haven't verified the data).
I'm going to run on the assumption that this is true, so here are my thoughts why this has occurred.
As we know, smoking is addictive. Nicotine cravings are real and if you have ever been around a heavy smoker when they are trying to quit, you have seen how irritable smokers can be without that regular nicotine hit.
However, what non-smokers may not be aware of is that cigarettes are brand addictive. Talk to any regular smoker (or even the casual after a few drinks smoker) and they all have their own preferred brand. There's a reason for this. Cigarettes taste disgusting. Or at least at first. However, over time a smokers brain will start to relate the taste of your Marlboro's to the nicotine release. It's almost like a Pavlovian response within the brain, as soon as that taste hits the brain knows it's about to get a nicotine rush. Needless to say, over time that brain starts telling a smoker that the taste is pleasurable and the smoker will enjoy the taste. However, if they switch to another brand, there is not a firm connection between that slightly different flavour and the cigarette will taste bad. Probably not terrible, but certainly not as good as their favourite brand. The product is brand addictive.
Lawsuits. The total potential liability for the tobacco industry was in the trillions, even back in the 90's. No one could afford those bills, so they a compromise was met via increased taxes to assist with the medical bills and impact on the health system caused by smoking.
Those pesky taxes have actually been a boom for big tobacco. Those very taxes designed to kill smoking, actually enables tobacco companies to steadily increase prices each year with every tax increase to offset declining volume. Now, normally in a declining market if you were to increase prices regularly (and achieve higher margins than Apple) customers would leave but...
Those very advertising bans designed to kill the industry, makes it impossible for new competitors to launch. Say, I decided to launch Tyso's Darts tomorrow. Somehow, I have the golden goose, the safest cigarette on the planet, has more nicotine than any competitor, it tastes delicious and smells great to non smokers. I can produce a pack for $3 and wholesale them at $12 in a multi billion dollar industry. Let's be greedy, pretend I can make them cheaper and quicker than anyone else whilst selling at a higher price. Surely, it's winner right? Nope. I'd probably sell only to myself. Because I can't advertise anywhere, my packets are hidden behind cabinet doors, I can have logos on the packets, I can't flog it on social media. In other words, I would sell nothing because I'm fighting against a brand loyal customer base and have no way of effectively getting knowledge of my product out there.
Big tobacco doesn't (or need to) innovate. Unlike your iPhone or any tech you own, smokers want their products to stay the same. So there is no need for huge innovation, research and development, product launches etc every year.
They have been able to pass mountains of their free cash flow back to shareholders and in the face of all the headwinds they have traded at cheap values. Like the old cigar butt style of investing, these companies have been priced for near immediate death (and I think they will die eventually) but as we have seen the death has taken longer than expected and there has certainly been value there for investors.
Speaking on the valuation side, lawsuits, declining volume, hatred for the industry and institutional mandates to avoid the sector again have lead to prices not reflecting the value of these companies. Now, I will say that most likely they will continue to trade at less than fair value to their cashflows and there is next to no chance that they will be priced fairly with the sector so hated.
I'm not telling you to buy cigarette stocks but it has got me thinking as to where the potential future cigarette companies will be.
As in, companies that are likely to be on the nose, trade cheap and have great cashflows, preferably with some sort of external force (i.e. government intervention) to provide reduced competition.
The first answer that sprung to mind was coal of all things, here's why:
With all our global carbon emission targets, eventually coal (for power) is going to form a miniscule if any part of our energy make up. Meaning, it's very unlikely to see new huge projects start as we move closer towards 2050.
Getting the governmental approvals, environmental approvals etc for a new coal mine is damn near impossible. Look at how long it took for Adani to get approved in North Queensland. Even if you found the biggest, highest grade coal deposit in the world, good luck getting governmental approvals in a timely manner.
Even if you could get the governmental approvals, arranging the financing will be difficult and expensive. Big banks, institutions etc do not want to be involved in the sector any more.
Investors (in particular ESG focused institutions) are not willing to hold these assets. Like with tobacco, meaning that these are highly unlikely to trade at the same ratios as an iron ore miner or gold miner. Meaning, they will be priced cheaper than fair due to the avoidance of the sector.
We have a sector where; eventually death of the industry (thermal coal) is almost assured, government actions (while well meaning) have meant that supply will be limited, financing arrangements mean that new projects are unlikely to launch (again limiting supply), companies that will be near permanently at a discount to their true cashflow value.
The recent boom in coal prices (long term it's totally unsustainable but when they collapse I have no idea) have enabled coal miners to create iron clad balance sheets (seriously look at the difference 2 years of high coal prices have made to Whitehaven Coal) but even if the price of thermal coal was to fall 50% from here, these companies have limited debt and the free cash flow will be enormous.
I think the future of energy is likely nuclear and renewable. But we have issues with the safety (or at least public perception) of the former and issues with the reliability with the later. In the mean time though, coal will remain a crucial part of the worlds energy matrix. Seriously, try telling the hundreds of million people globally without electricity that we could provide that to them but we are choosing not to because of ESG reasons).
However, there are a range of other sectors that have popped into my mind that may have similar characteristics to the tobacco industry; gambling (addictive, governments both restrict and love the operators, reasonably recession proof), oil (hated but necessary until we can find a substitute for the myriad of uses it has), alcohol (can be addictive but doesn't have brand loyalty a serious alcoholic may prefer single malt scotch but desperate enough will drink box wine etc, but not on the nose enough to be a "hated" investment), the internal combustion engine manufacturers (ICE will die but I don't think many, if any, of the big players will die) etc etc.
As many of you may know, I am a contrarian at heart.
I like the underdog, believe that people (and markets) routinely miss price the risk or probability of events occurring (particularly in the spaces where said event is devasting to consider. I.e. the collapse of CDO's, ABS's and MBS's in the GFC particularly in the higher tranches) and ultimately the biggest risk within your portfolio is not that you will have volatility but the permanent loss of capital.
There is a key distinction and any financial text book, professional or whatever that tries to tell you that the risk of owning something can be judged by "how much it moves daily" or by how much it moves relative to the market is wrong.
Commonly hated investments can be great drivers of value if you are willing to stomach the pain of owning investments that are hated.
Any who, I think I've waffled on enough for today so I might leave it here.