Last Updated on December 4, 2020 by Oddmund Groette
Some months ago I wrote an article about the historical performance of so-called “sin stocks”. Tobacco companies have performed the best in the US, and alcohol stocks in the UK. In this article, I briefly argue for the reasons why and why they most likely continue to outperform.
Tobacco stocks outperform because they have high margins, regulation creates a big moat and make it hard to compete, it’s impossible to create new brands, the price is inelastic, and they “always” trade at a discount to the market.
High margins and cashflows:
Margins are very high. For example, 27% of the revenue ends up as free cashflow for Philip Morris and CAPEX is a tiny 3% of the revenue. Little working capital is required and more can be handed back to shareholders in the form of dividends or buybacks.
Regulation creates a big moat:
Tobacco is among the most regulated industries on this planet. Everything is regulated in detail: how to package, where to display tobacco in the stores (some countries don’t allow to display it all), it’s illegal to advertise in most countries, etc. The regulations are almost endless. Needless to say, this obviously creates huge barriers to entry for potential competitors. The big tobacco companies have the arena all by themselves.
Many decades of regulation and constant litigation from governments and activists have made tobacco companies develop enormous knowledge and expertise in this field. New competitors don’t have this knowledge. Why did Altria take a strategic position in JUUL Labs? I believe the main reason is that Altria knows how to navigate among the lawmakers, something JUUL clearly needs right now. I believe this acquisition will turn out nicely later.
Difficult to create new brands:
Because tobacco ads in most countries are banned, how can new companies create new brands? It’s basically impossible unless you innovate new products like IQOS or vaping. The current tobacco brands have been around for a very long time and change is very slow.
Unlikely to be outright banned:
I have never heard from serious sources suggestions to outright ban tobacco, and I believe this is unlikely to happen.
In any other industry, I believe it would be likely to raise concerns about antitrust. But to this day I have not heard any regulator mention this about tobacco companies, even though the market is controlled by just a few big multinationals. It’s close to an oligopoly.
Tobacco has been in use for a long time:
Tobacco has been used for centuries, and anything that has been in existence for many centuries is unlikely to disappear overnight. Tobacco is timeless. Nassim Taleb explained the Lindy effect in Antifragile, and this is perhaps very relevant for tobacco.
The demand for cigarettes has historically proven to be inelastic. If prices go up, smokers simply keep smoking no matter what. The addictive nature makes users less sensitive to price. Not even social stigma stop smokers.
The trend of falling cigarette shipment being offset by higher prices has continued for a long time. In the US a pack of 20 cigarettes costs around 8-9 USD, while a similar pack costs around 11-14 in Europe. In Australia, a pack costs closer to 20 USD (source: Morningstar). Altria shipped 40% fewer cigarettes in 2019 compared to 2010, but EPS increased from 1.5 to over 4 in the same period.
“Always” cheaper than the market:
Tobacco companies are always fighting litigation and activists. As such, headlines are steady negative and this leads to a discount in valuation compared to the overall market. Thus buybacks and DRIP can be done at cheaper prices than in other stocks, something that pays off further down the line. As I have written before: if you are a net buyer of stocks in the future you want to pay as little as possible for the earnings:
If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.
Back in 1999, Philip Morris was trading at very low valuations because the Marlboro-man was outlawed: tobacco advertising was banned from 2000. This turned out to be a good time to buy Philip Morris as it compounded double digits in the next decades.
ESG-investing is on the rise and yet again tobacco stocks are out of favor. Most institutions can’t invest in tobacco stocks and I suspect most of the fund managers don’t smoke themselves (neither do I). I believe the common perception is that tobacco companies are going to “extinction” (always).
No investments are guaranteed a positive return. Not even tobacco stocks. However, a constant flow of negative news is exactly what makes them a good investment. The market is trading at a P/E of 25 and higher, while Altria is at 10 and Philip Morris at 15. Over the next decade, I believe both will return double digits return.
Other relevant articles:
- Is Altria a good investment at a P/E of ten?
- 11 reasons to own Philip Morris International
- Sin stocks and performance
Disclosure: I am long both Altria and Philip Morris. I am not a financial advisor. Please do your own due diligence and investment research or consult a financial professional. All articles are my opinion – they are not suggestions to buy or sell any securities.