There is a hunger for more information on my thought process when considering an investment in an individual stock. Index funds are still the best choice for most people as they are low-cost and are easy to set up and automate. Yet, the questions still come in.
Investing some of your liquid cash into a promising business is not only exciting, but offers the opportunity for outsized gains. Catching Microsoft or Amazon before they started their assent to the moon would increase the returns of any portfolio. Buying a good business increases the chances your returns will be higher than mere index funds.
Recently I published a review of the financial statements of Altria (MO) and why this might be a good company to invest in. However, I go much deeper than just the financials before plopping down my hard cash. Management needs to be assessed; how the company treats shareholders is important; is there a competitive advantage?
It is still possible today to find stocks trading at incredible values. Apple (AAPL) has loads of cash. A large portion of AAPL’s stock price is the cash they hold. The enterprise value reflected in the stock is compelling even as the price has climbed and U.S./China trade issues abound.
MO will be our guinea pig again today as I lay out my investment thought process. The reason for this is I own MO and have recently added to my position so my reasoning is fresh. I recommend you read the first post linked two paragraphs above first. You can get a clear idea of why MO is worth considering from the financial statements before continuing. It is a good idea to bookmark these two posts so you can review the process before buying your next stock.
But there is so much more. Like AAPL, MO has hidden bonuses for owners of the company and risks to consider.
Money in the Drawer
Back in the 1980s when Peter Lynch was the name you listened to when it came to expert stock advice a unique situation existed.
Savings & Loans were going public at a torrid pace. Once it was discovered how much money could be made, every S&L couldn’t covert to a bank and issue public shares fast enough. Lynch made a killing for the fund (Magellan) he managed at Fidelity.
The biggest problem was getting enough shares. Non-customers of the S&L were frequently locked out of the offering. Even depositors of the S&L could only buy a limited number of shares.
Most S&Ls were small. But there were thousands of them!
Shares usually went public at $10 or thereabouts and almost always saw a sharp increase the first day of trading. Gains of 60% and more in the first month of trading were not unheard of.
Lynch clued this accountant into the secret early on. Since the S&Ls had no current shareholders technically all the money from the Initial Public Offering (IPO) went back into the bank to grow the business or pay out dividends, usually both.
Lynch said it was like buying a company and finding your payment in the desk drawer after the purchase. Whatever the bank was worth before was now worth the same, plus all the new monies.
I like finding money in the desk drawer!
More than Cash
The S&L days are history now. Without mentioning names, a certain accountant opened accounts in every S&L he could find in NE Wisconsin.
Interest rates were higher then so tying up money still enjoyed a return. Usually a $1,000 or so in a savings account of some sort qualified you for the maximum allotment.
When the announcement was made I would sign up for the maximum amount of shares and wait for the day it began trading (usually six months or so at most).
I didn’t sell as soon as the bell rang. All that new money meant the bank was worth around double the IPO price and if management invested wisely returns could be even larger. Most $10 S&P IPOs traded in the mid-20s a year or so out. I sold when full value reached or close to it.
Selling wasn’t the first priority. Sometimes rumors of banks looking to consolidate the industry added to profits. (Remember, the prior S&Ls had a lot of cash on the books, making them prime takeover candidates.) I sold many, but also kept a select few. Some didn’t pan out the way I wanted so I sold (usually at only a 100% profit).
These new banks that did get bought out could generate over a 500% return for the original investors in a few short years.
One important point to clarify. I never bought more shares of these prior S&Ls after they started trading. What I was allotted of the IPO is what I got. Any additional shares purchased would not be cash in the drawer. With so many banking institutions it was obvious this was a smash and grab.
MO Money
What does the demutualization of savings & loans have to do with Altria (our stock in the spotlight) or any other stock investment?
While it is true the massive profits from S&Ls is over, plenty of lessons can be learned. IPOs are a risky venture and not for most investors. (I don’t recommend IPOs because the good ones are bought out by the large funds and the poor ones you don’t want.)
Many companies have hidden treasures buried in their financials. Reading the balance sheet will not reveal these gems. For that you need to read company SEC filings like the 10-K (annual report) and 10-Q (quarterly report).
Risks
MO is in the tobacco business even as they work hard to transform into a smoke-free company.
Transformation usually has some pain. Couple that with a large number of funds and investors refusing to invest in tobacco for ethical reasons and you have a unique environment.
Tobacco use is down. A lot! Cigarette volumes are dropping around 5% a year now as vaping is gaining ground. This cash-cow of the industry is facing serious threats.
Constantly raising prices dulls the pain, but eventually a limit will be reached where the negative elasticity from price increases turns positive*. Cigarette usage peaked in 1952 and has declined slowly since, only to accelerate with other alternatives.
No matter how positive a picture I paint the remainder of this post on MO does not subtract from the issues facing MO as tobacco use decreases.
Every investment, even those juicy S&L demutualizations, had risks.
Know What You Own
Some businesses have loads of cash sitting around, like AAPL. AAPL has something like $47 per share in cash in its accounts. AAPL closed the day I’m writing this at $200.48 per share. That means about 23% of your investment in AAPL is buying the cash in the checkbook. Looked at another way, the $200 price minus the $47 cash per share means investors are valuing AAPL’s enterprise at about $153 per share currently.
Unlike AAPL, MO doesn’t carry large amounts of cash per share on the books. Compared to normal operating expenses, MO generally uses most of its cash in operations and returns the rest to shareholders in the form of a dividend and share buybacks fairly quickly.
However, Altria has some very interesting assets under the hood. MO owns 10.1% of Anheuser-Busch Inbev NV (BUD). BUD is one of the largest brewers in the world with over 400 beer brands.
BUD closed with a market cap today (August 12, 2019) of $163 billion. MO, for comparison has a market cap of $85.9 billion at today’s close. In other words, MO owns $16.463 billion of BUD, or just over 19% of the price MO is trading for at today’s close.
Put another way, almost $9 of each share of MO is really BUD! (MO has just under 1.9 billion shares outstanding.)
With MO closing today at 45.98 and BUD nearly $9 of that price means everything else MO owns and does is valued by traders (hard to call them investors) at ~ $37 per share.
Holy Smoke!
The cigarette business still brings in the bulk of profits used to pay those juicy dividends. This year marks 50 straight years of dividend increases.
Investments like BUD pay a dividend to MO each year so MO has cash flow while BUD grows its business.
Not all of MO’s investments pay dividends. . . yet. Late last year MO opened the checkbook (added debt) to buy 35% of Juul (vaping) for $12.8 billion and another $1.8 billion for 45% of Cronos Group (CRON) (weed). MO also purchased 80% of on! (oral nicotine)for $372 million in early June this year.
on! is a small investment and not large enough for this discussion.
CRON is a very long-term play in the expanding marijuana market. I don’t expect CRON to make an equity contribution to MO for at least 5 years, probably longer.
To keep this simple let’s assume on!, CRON and other minor investments held by MO are worth zero. They do have value since MO could always sell the CRON shares they hold. $1.8 billion of a $85.9 billion market cap is only 2% of the stock price, or less than a dollar per share.
Growth Engine
If you can swallow your ethics and see your way to ownership of some MO it might be worth your time. While other cigarette companies are facing the same sales declines, only MO has a real plan to live, even thrive, another day.
MO has always made investments in its future. The company also thinks long and hard about their shareholders. (Maybe because nobody else will be their friend.) Dividends at the company have always been rich. Spin-offs in the past (Kraft and Phillip Morris International come to mind) have also unlocked shareholder value.
All that aside, I think Juul has the possibility to be the best investment MO has ever made. At the beginning of this year Juul was expected to generate $3.4 billion in sales. On the latest earnings conference call, Chairman and CEO, Howard A. Willard III, said Juul sales grew 194% in the first half of 2019! And this is a slow down?
By this accountant’s calculations, the current growth rate pegs Juul for $3.8 billion in sales for 2019. To top it off, Juul is expected to make an equity contribution (sorta like a dividend) to MO later this year! Willard said it would be an immaterial amount, but an equity payment to MO only a year after purchase! Material equity contributions might be sooner than anticipated.
Juul has plenty of issues domestically. Regardless the outcome in the U.S., Juul is set to have a massive international business as well. There are certain to be setbacks, but Juul is set to be a massive player in the nicotine market. And MO is the perfect partner with experience handling these issues.
Juul sales growth rates must come down in a few years. At these growth rates Juul would have over $100 billion in sales in 5 years. MO had just under $20 billion in sales last year.
Juul cannibalizes MO’s cigarette business while doing the same to every competitor domestically and increasingly internationally.
I do not believe MO’s investment in Juul is worth only $12.8 billion. I think it is more. Someday MO may absorb all of Juul or spin it off. I don’t know the future. Regardless, MO will see the value of Juul climb a lot higher in an unnamed accountant’s opinion.
It is not inconceivable for MO’s ownership in Juul to be worth more than the rest of the company combined. Juul has the promise of a fat dividend stream in the near future.
Within a few years MO will be growing faster than they have in memory as BUD, CRON, on!, Juul and other investments add to profits. Dividends are currently safe and still growing. It is easy to see where future dividends will come from.
Final Sales Pitch
MO is a steal because too many don’t consider investing in tobacco. That is a shame. Reasonable values are hard to come by at current market prices. I invest to make a profit and expect you do as well. Therefore MO should be a consideration.
Altria is changing. Once a cigarette company, is now transforming into a better company. Vaping isn’t a perfect solution, but it is better than smoking. Beer isn’t good for you and I doubt weed is either. Good for you or not, people keep buying things they want and they want nicotine.
MO has a solid management team willing to work for the shareholders. That is hard to find these days. MO buys back stock, but gives the bulk of profits to owners in cash (dividends). While MO has risks there is a lot to like about this company. It’s a business I want to own and do.
MO also has a serious competitive advantage. Regulations and limited advertising opportunities keep upstarts at bay. MO’s commanding lead allows them to control the market. Juul has a similar lead in vaping. Now you know why MO bought 35% of Juul. The closest competitor will be a very distant second.
Warren Buffett once said about tobacco companies: the product costs a penny to make and is addictive. What’s not to like?
I think Buffett never bought MO because he wants to keep a clean reputation. Coca-Cola was as far as he could go with an addictive product.
And remember this: People risked (and in some states still risk) going to prison for a decade or longer to smoke weed, a non-addictive drug according to many.
Nicotine is addictive. What are the odds people will stop using it?
Exactly.
The market is open tomorrow. All those who don’t like tobacco are selling. You might want to pick some of that up while you can at a reasonable price.
Oh, and the dividend is slated for an increase in two weeks. Nothing like getting a raise the first month on the job.
* Price changes have an element of elasticity. If sales drop 10% when prices are increased 10% we say it is elastic. If sales drop only 2% when prices climb 10% we say it has negative elasticity. When the opposite happens (10% price increase causes sales to decline 12%) it has positive elasticity. Economics students will note price elasticity of demand is always negative because the demand curve slop is leftward. A better way to say this is tobacco price are currently inelastic (sales drop less than the price increase). However, a point will come when they are elastic (sales drop faster than price increases). You can read more here if you want a technical review of price elasticity.
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William
Tuesday 22nd of October 2019
Hi Keith are you planning on continuing accumulating MO shares at these price levels? Any other stocks that are interesting to you at the current level?
Keith Taxguy
Tuesday 22nd of October 2019
William, not only am I planning to add more shares of MO to my portfolio, I have. I also added a bit to my PM holding, too.
I'm always reading up on other companies. Values are pretty well reflected in the market right now. BA and JNJ are on my watch list (I own at least one share so I get news reports sent to my account). JNJ has legal issues however and BA has a lot to work through as well. Maybe someday, just not yet. I like FB at a lower price. FB management bothers me however so while I think they have a massive brand with a mote, leadership is a concern. I'd buy MSFT at a lower price. Waiting. UNH is also interesting. It went down quite a bit, but not enough to justify buying. We need a Medicare for All scare to make it a screaming buy. I like screaming buys.
Was also watching COP and MMM, but sold my solitary share as I don't see enough to be interested in the future. MMM, for example, has way too much litigation risk for me to buy a serious amount of the company. My attitude is that if I wouldn't buy the entire company if my finances allowed I shouldn't buy any.
I also bought some AAPL (I said some). The recent run higher has made an entry point too high for me to continue adding to my position.
I can't complain however. When MO dropped below 40 briefly it was like manna from heaven. Locking in an 8% dividend yield brings a tear to my eye. I still cannot believe my good fortune. I also sold naked puts when we were deep in the trough. If earnings are good you forget these prices for a long time, if ever. Still, 8% for this accountant is locked in.
Alex Ramsey
Wednesday 28th of August 2019
Hey Keith, where do you stand on Altria's payout ratio? The past 6 months showed nearly a billion dollar reduction in sales compared to first 6 months of 2018 in their smokeable products. I love the dividend I receive from them but such a high payout ratio has to concern the investor right? Thanks for your time!!!
Keith Taxguy
Thursday 29th of August 2019
MO's payout ratio has hovered around 80% for 30 years. Of the remaining 20% of FCF they buy back shares. They just don't need that much capex. The payout ratio is skewed due to the first quarter when they has expenses due to investments before they could adjust completely. Nothing unusual about that.
The real issue now will come from the details of the merger with PM if it takes place. PM's payout ratio is higher, but they have started growing profits again.
The real advantage MO has it its investments and pricing power. If you play the long game (I do) then MO is a steal right now. Juul will start to add to MO's profits later this year and should increase smartly these next several years. CRON is a really long game IMO.
The dividend is safe and coming from profits (not a return of capital as some tobacco companies are doing). MO is not a cigar butt (nice analogy) Warren Buffett built his early career on. They have many routes to higher profits and you get paid very well while you wait.
Todd
Wednesday 28th of August 2019
What do you think about the potential re-combination of Altria and Philip Morris?
Keith Taxguy
Wednesday 28th of August 2019
I have no opinion until I see the terms of the merger. Since I own a part of both companies the combination should produce some interesting economies of scale. For example. iQOS is a PM product sold by Altria in the U.S. A merger could speed this process.
The biggest benefit, and the reason for the merger talk, is Altria's stake in CRON and Juul. A merger should allow for a serious international expansion of Juul. Combined, this will will a very large company and the largest in the tobacco industry.
Investors are at there most illogical, too. MO was up 10% in the morning and down in the afternoon 4%. PM was also down. How can a merger cause both companies to lose where there are such strong synergies? Me, I just keep adding to my stack, enjoying the massive dividends. When they start loving these businesses the gains will be incredible.
Josh
Tuesday 13th of August 2019
Keith,
Can you help me understand Vector Group's financials? They are a tobacco company and real estate company combined. They pay a stock dividend and cash dividend every year, all of which is considered "return of capital." They show negative equity and growing every year that they add those shares in the stock dividend. They earn less than their dividend payout by far. Yet, they can still borrow money. They have plenty of cash on their balance sheet. They have paid the dividend and stock dividend for over 20 years. What am I missing with this company that provides them a lifeline to continue?
ticker: VGR
Keith Taxguy
Wednesday 14th of August 2019
I've reviewed VGR, Josh. The diversification into RE didn't pan out as well as expected (and as I expected) so I never bought a share of the company. IMO VGR is in a very bad place; the dividend is not sustainable. I would avoid.
JR
Tuesday 13th of August 2019
Sounds like an inordinate amount of mental energy researching a company whose business model is: kill people.
I do think you're likely to sacrifice performance if you go full hog ESG and exclude entire sectors and industries, however. What to do?...
Have you done any writing on ESG/sustainable investing?
Interesting side note on S&Ls of yesteryear. I heard someone say something similar about credit unions, i.e. you should open up accounts at credit unions with the hope of some future corporate action. Any thoughts there?
Keith Taxguy
Tuesday 13th of August 2019
JR, ESG investing has a rough track record. It has improved of late, but there are a lot of disasters in the world of "doing good". The real question is: What is good? Beyond Meat is claimed to be less healthy than real meat. So do we invest in it? Is Tesla good? Consider the chemicals and environmental degradation caused building solar panels. Banks must good. Right? But banks thrive by saddling the rest of us with a heavy debt burden and other fees. Coke makes us obese, packaged foods the same. And if you invest in index funds you already own MO, along with British-American Tobacco, Lorillard and a few more. Without a reputation to uphold, like Buffett, I draw the line at making money profitably. I'll let the government decide what is and is not legal.
I heard the credit union thing about as often as I hear the penny is going away so stock up. With the S&Ls I didn't anticipate something that might happen. Only once is started full force did I place my investments. If credit unions go the way of S&Ls I'll be sure to load up, but I'll miss the first few. I'm okay with that.