J#24 – Why Tobacco Companies can be Among the Most Lucrative and Solid Dividend Paying Investments (Part 1)

I am looking at four different tobacco stocks from Jamaica to Indonesia to determine whether they are a good fit as potential investments for double digit dividends. This journal is the first of a four-part series discussing what to look for when purchasing profitable dividend-paying investments.

After consulting with potential investors, colleagues, and advisers, I am encouraged to see that there is great interest in a Double-Digit-Dividend Fund, which would aim for a blended portfolio yield of over 10%, and pay out the distributions quarterly. I’m working earnestly on making it a reality. As part of that, I am obviously also doing the research on potential investments for the Fund to make.

All four of tobacco stocks I’m analysing have histories of more than a decade reliably paying out dividends to investors.

For the fund, some or all of these stocks–combined with other stocks, such as Jupiter Mines and Twiga Cement, which pay dividends in the low to mid-teens–may make a good fit, and would deliver a blended double-digit return on our money.

The potential universe of investments is broad and these journals are written to provide you with a flavour of our investment and thought processes.

Today, I want to give you a taste of these tobacco stocks and why we are looking at tobacco as an industry.

Gene Hoots put it aptly in his book, “Going Down Tobacco Road”, where he points out:

“Tobacco, for more than eleven decades, gave investors unbelievably good and consistent returns. One dollar invested in tobacco stocks in 1900 would have grown to $6.3 million in 2014, an annual compound return of 14.6 percent, beyond any other industry over that long period.”

Established players such as British American Tobacco, Japan Tobacco, Philip Morris International and Altria are able to achieve these long-term returns as they are capital efficient companies with wide “economic moats”.

What is a capital efficient company? Porter Stansberry in his article “The Single Best Way to Make a Fortune in the Markets” gives a good definition. His article can be read here.

Capital efficient companies, as Porter elaborates, are companies that:

can grow sales without the need for additional capital expenditure (capex) to acquire, maintain, and upgrade existing physical assets, such as plant and equipment, that are used for manufacturing their product;
usually return more capital than they require for their annual capex requirements; and
also usually sell high-margin products in well-established and stable industries.

The table reproduced here, from Stansberry’s article, lists the top 20 stocks in terms of returns by the S&P 500 in the 50 years between 1957 and 2007.

Surprise, surprise, who is on top of the list? Philip Morris, a tobacco company.

The list is likely to have changed with the recent focus on FAANG stocks, but nevertheless, what has been proven in the past remains: capital efficient companies, such as tobacco companies, make solid and consistent long-term investments. Moreover, for our purposes, since they don’t need to reinvest anywhere near all their profits, they tend to pay them out as generous dividends.

Tobacco companies also have a wide “economic moat”, a phrase popularized by Warren Buffet, who first learned of the concept from Phil Fisher. Businesses with a wide moat are those that are easily able to maintain competitive advantages over their competitors and new market entrants in order to protect their long-term profits and market share. They have strong balance sheets and operating margins where they can easily deploy their cash to develop new products and sell those products via established marketing and product delivery channels. In short, they are able to defend and grow their businesses.

There is a general perception by investors that the economic moat is shrinking in the tobacco industry due to the following threats:

Government public health campaigns have reduced tobacco demand. Likewise, government taxes have increased to serve as a deterrent to smokers from continuing to smoke and as an avenue to boost public revenue collection.
A switch of consumer demand and tastes from smoking tobacco to the use of electronic cigarettes (‘e-cigarettes’). The perception is consumer market share is therefore taken away from traditional cigarette/tobacco companies. An electronic cigarette is a nicotine delivery electronic device that simulates tobacco smoking by vaporising a nicotine solution that is inhaled by a smoker. The term “vaping” is therefore commonly used with e-cigarettes.

In developed countries, government public health campaigns and increases in tobacco excise duty have seen a fall in smoking rates. But is this the case in developing countries?

Tobacco companies have strong cash balances and great distribution and marketing channels for their cigarettes. Are they able to use this to defend and grow their economic moat by manufacturing and selling e-cigarettes too? Have they been successful in their execution?

Let’s look at three of these developing countries, together with the Czech Republic. The Czech Republic is classified as a “developed” or “advanced” economy for a lack of a better term. I dislike the use of terminology that differentiates and categorises a country’s economy as “advanced” or “developing”. In my view, they are all developing and in some cases, an “advanced” economy may well be declining.

The countries and companies we shall look at are:

Country	Stock Exchange	Company	Ticker
Indonesia	Jakarta Stock Exchange	Philip Morris Indonesia (HM Sampoerna)	HMSP.JK
Kenya	Nairobi Stock Exchange	British America Tobacco Kenya	BAT.KE
Jamaica	Jamaica Stock Exchange	Carreras Ltd (subsidiary of British American Tobacco)	CAR.XJAM
Czech Republic	Prague Stock Exchange	Philip Morris (Czech Division)	TABAK.PR

We’ll adopt a top-down approach to our analysis. Specifically, the questions we shall answer:

Are the smoking rates materially declining in each of the above countries?
Is there a switch in government policy to materially increase excise taxes (and thereby to potentially eat into the company’s profits)?
Does the company’s revenue numbers reflect an adverse impact due to consumers switching from smoking tobacco products to e-cigarettes?
Are foreign exchange rates, as a proxy to the country’s macro environment, conducive for us to invest there? (To be tackled in Part 2)
Are the dividend yields of these companies attractive enough for us? (Discussed in Part 3)
What metrics can we use to measure capital efficiency and which of these companies are a
great buy? (Discussed in Part 4)

SMOKING RATES

The charts below show the percentage of smokers in each country’s population as well as their year-on-year changes in smoking rates for 2012 to 2016. The data is from www.macrotrends.net who source their data from the World Bank. The data for 2016 is the last update available.

The conclusions we can reach are:

Year-on-year saw only a 0.5% increase/decrease in smoking rates. In the case of Indonesia, there was a 0.4% to 0.5% increase for each of the consecutive years! (Probably due to more women picking up smoking. Nearly all Indonesian men already smoke believe it or not).
E-cigarettes were introduced to the market in 2011. In 2011 there were about 7 million adult e-cigarette users globally, rising to 41 million in 2018 [source: Wikipedia]. There is nothing to indicate that there was a material impact from this on regular tobacco consumption patterns in our four target countries for analysis, between 2012 and 2016.

REVENUES & EXCISE DUTIES:

The World Bank data on smoking rates is only available up to 2016. For the period 2016 to date, our analysis uses revenue/sales results of the 4 companies mentioned above to evaluate tobacco demand. This data is reproduced in the charts below.

Year-on-year revenue numbers are published net of excise duties and value added taxes (‘VAT’). The trend of excise duties and VAT taxes as a percentage of revenues is a valuable indicator to signal to us whether there is a switch of government policy to taxing their respective tobacco industries more heavily.

The year-on-year revenue numbers of each of the four companies we are analyzing is also a valuable indicator to reflect whether their customer market share is adversely impacted by a switch of consumer tastes to e-cigarette products, and/or they have successfully defended their market share by various business initiatives including introducing e-cigarette products to their range of customer product offerings.

The conclusions we can reach are:

There are NO material changes in smoking demand. The effects of e-cigarettes are not affecting revenues of the four companies we are analysing. Revenues are constant if not growing.
There is no noticeable switch to government excise duties and VAT policies. The percentages of taxes to revenues have remained constant over the years.

The “economic moat”, using Warren Buffet’s terminology, of these 4 companies remains wide.

Metrics such as gross margins, return on equity and invested capital are some of the measurements used to measure the width of the economic moats of these companies. These metrics, together with the dividend returns of these companies, are analysed in our four-part journal series.

Until next time, good investing.

Peter