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Why Tobacco Stocks Outperform: A Compelling Investment Thesis

Last Updated on 10 February, 2024 by Abrahamtolle

I wrote an article about sin stocks’ historical performance some months ago. Tobacco companies have performed the best in the US, and alcohol stocks in the UK. In this article, I briefly argue why and why they most likely continue to outperform.

Tobacco stocks outperform the market because they have high margins, the regulation makes it hard to compete, it’s impossible to create new brands, the price is inelastic, and they “always” trade at a discount.

High margins and cashflows

Margins are very high. For example, 27% of the revenue ends up as free cash flow for Philip Morris, and CAPEX is a tiny 3% of the revenue. Only small amounts of working capital are required; thus, more can be returned to shareholders as 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 tobacco to be displayed at all), it’s illegal to advertise in most countries, etc. The regulations are almost endless.

This creates enormous 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.

Difficult to create new tobacco brands

Because many countries have banned tobacco ads, how can new companies create new brands? It’s 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.

Tobacco stocks are unlikely to be outright banned

I have never heard suggestions from serious sources to outright ban tobacco, and I believe this is unlikely.

Antitrust regulations?

In any other industry, I believe it would likely raise concerns about antitrust. But to this day, I have not heard any regulator mention this about tobacco companies, even though just a few giant multinationals control the market. 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 existed for centuries is unlikely to disappear overnight.

Tobacco is timeless. Nassim Taleb explained the Lindy effect in Antifragile, perhaps very relevant for tobacco.

Inelastic pricing

The demand for cigarettes has historically proven to be inelastic. If prices go up, smokers keep smoking no matter what. The addictive nature makes users less sensitive to price. Not even social stigma stops smokers.

The trend of falling cigarette shipments 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!

Tobacco stocks are”always” cheaper than the market

Tobacco companies are always fighting litigation and activists.

As such, headlines are usually negative, leading to a discount in valuation compared to the overall market. Thus buybacks and DRIP can be done at lower prices than in other stocks, which 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.

-Warren Buffett

In 1999, Philip Morris was trading at very low valuations because the Marlboro-man was outlawed: tobacco advertising was banned from 2000. This was an excellent time to buy Philip Morris as it compounded double digits in the following decades.

Conclusion: I believe tobacco stocks will continue to outperform the market

ESG investing is on the rise, yet again, tobacco stocks are out of favor. Most institutions can’t invest in tobacco stocks, and I suspect most fund managers don’t smoke themselves (neither do I). The common perception is that tobacco companies will be “extinct” .

No investments are guaranteed a positive return. Not even tobacco stocks. However, a constant flow of negative news makes them a good investment. The market trades at a P/E of 25 and higher, while Altria is at 10 and Philip Morris is at 15. Over the next decade, I believe both will return double digits return.

Other relevant articles:

Disclaimer: 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.  

FAQ

– What contributes to the high margins of tobacco stocks, such as Philip Morris?

High margins result from significant free cash flow, low CAPEX (capital expenditures), and minimal working capital requirements, allowing more returns to shareholders through dividends or buybacks.

– How do tobacco stocks deal with negative headlines and litigation?

Constant negative headlines and litigation contribute to tobacco stocks consistently trading at a discount to the overall market. This discount allows for favorable buybacks and dividend reinvestment plans (DRIP) at lower prices.

– What is the role of ESG investing in the current perception of tobacco stocks?

Tobacco stocks are currently out of favor in the rising trend of ESG (Environmental, Social, Governance) investing. Many institutions avoid investing in tobacco, contributing to the perception that these companies may become “extinct.”

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