fbpx

J#28 - How we measure potential Investment Returns of our tobacco companies
(Part 4)

This is the fourth and final entry in our four-part series analyzing five tobacco stocks as potential capital efficient, dividend-paying investments.

To recap, our investment conclusions so far are:

world map-tobacco sign
CompanyDividend Yield
(Net)
Potential Recommendation
(Subject To Further Analysis)
Philip Morris (Czech Division)9.8% for EU and EEA residentsPotential BUY recommendation for EU and EEA residents.
Potential "Fill-In" recommendation for the Fund - a WHT of 35% and a net yield of 7.5%.
British American Tobacco Kenya PLC8.3%Potential "Fill-In" Recommendation for the Fund.
Carreras Ltd (Jamaica)6.6%NOT a BUY Recommendation.
Currency Risk (see J#25) and too low a net dividend.
HM Sampoerna (Philip Morris Indonesia)6.8%NOT a BUY Recommendation.
Dividend too low.
Eastern Company SAE10.5%Potential BUY recommendation for the Fund.

Carreras Ltd is located in Jamaica, a country riddled with foreign currency risks which precludes us from investing there, according to our investment rules.

HM Sampoerna, on the other hand, dropped out of our candidate list due to its low net dividend yields. However, if you are happy with a 6.8% net dividend yield, read this article written by my business partner, Tim, where he talked about Sampoerna as a potential investment.

The remaining three companies, Philip Morris (Czech Division), British American Tobacco (Kenya) and the Eastern Company (Egypt) remain as potential BUY recommendations as they have, to date, met the Double Digit Dividends standard. Not only they have relatively good net dividend yields but also have the characteristics of strong, capital efficient companies.  The metrics we looked at were whether they had:

  1. Strong history of dividend payouts (measured by the company’s dividends per share).
  2. History of high profit margins.
  3. Low leverage / debt levels (measured by a company’s debt-to-equity ratio).

As a rule of thumb, these three characteristics constitute capital efficient companies.

We have classified our BUY recommendations as an out-right BUY or as a “Fill-In” Recommendation.  A Fill In recommendation is a position we take as a placeholder until we find other stocks that pay dividends well into the double digits.  We prefer to make between 9% and 10% rather than sit on cash with its near zero returns.  Please refer to Journal 26 for more details.

RETURN ON EQUITY

In this journal we take our analysis one step further.  That is, we measure the company’s return on equity as an overall measure of the company’s capital efficiency.  Capital efficient companies have a high return on equity, a return the company can utilize to generate future profits to distribute to shareholders as dividends. 

“Return” is measured by the company’s net income.  “Equity” is simply the book value of the company’s recorded assets minus its liabilities as shown on its balance sheet.  The Return on Equity (‘ROE’) of a company is therefore a financial ratio of net income divided by shareholders’ equity.  To put it another way, the ROE measures how much profit it can generate for every dollar of equity it has.  The financial ratio is:

ROE formula

The ROE ratios for our five tobacco stocks are reproduced in the table below.

CompanyCurrencyNet Income
(Local Currency)
Shareholders' Equity
(Assets - Liabilities)
ROE
Philip Morris (Czech Division)Czech Koruna4,021,000,0009,435,000,00043%
British American Tobacco Kenya PLCKenyan Schillings3,885,649,0009,715,210,00040%
Carreras Ltd (Jamaica)Jamaican Dollars4,804,642,0001,772,496,000271%
HM Sampoerna (Philip Morris Indonesia)Rupiah13,722,000,000,00035,680,000,000,00038%
Eastern Company SAEEgyptian Pounds3,590,550,00011,090,432,00032%

We have included Carreras Ltd and HM Sampoerna in our analysis even though they are no longer buy recommendations simply for the sake of comparison to the other three tobacco stocks.

All of them have exceptionally high ROEs that are greater than 30%.  They are, as measured by their respective ROEs, capital efficient companies.  In the case of Carreras, its 271% return looks abnormal.  Their ROE has been in the high 150%+ range since 2016 financial year.  I could not locate a reason for its high ROE, it may well be that they are equity “light” as a result of prior year distributions. 

The next question we pose in our investment selection process is — can we buy them at a good or “cheap” enough price, to use a colloquial term.  In Double Digit Dividends we are focused on the dividend yields.  If the company is capital efficient and can pay a healthy net double-digit dividend, the company is at a price that is “cheap” enough to buy.  But there is another metric we can, and do, use.  That is, Price to Book.

PRICE TO BOOK

Book value (‘B’) is the company’s recorded assets minus its liabilities shown on its balance sheet.  It is the same value as the company’s equity we use in the ROE calculation.  Why don’t we call it Price to Equity?  Well, historically investors have always called the ratio “price to book value” (just to confuse us?), so we’ll follow convention.

Price (‘P’) is the current price we would have to pay for the company as quoted on the stock exchange.

The ratio therefore is:

Price to Book formula

The P/B ratios for our five tobacco stocks are reproduced in the table below.  

CompanyCurrencyPrice Per ShareShareholders' Equity Per SharePrice / Book
Philip Morris (Czech Division)Czech Koruna13,680.003,436.684.0
British American Tobacco Kenya PLCKenyan Schillings359.759.7237.0
Carreras Ltd (Jamaica)Jamaican Dollars6.410.3717.6
HM Sampoerna (Philip Morris Indonesia)Rupiah1,420.00306.754.6
Eastern Company SAEEgyptian Pounds11.974.932.4

Stock prices as of 15 November 2020

At first glance, BAT Kenya and Carreras look expensive with a double digit PB ratio.  We generally like companies with a single P/B ratio, however this single-factor analysis is too simplistic.  A better approach is to compare P/B to the company’s ROE.  Investors are inclined to pay a higher price for a corresponding higher ROE (i.e. returns). 

A high P/B ratio with a low ROE would indicate an overvalued company.  And, conversely, a low P/B ratio with a high ROE would indicate an undervalued company.  It is these mismatches that provide us with opportunities to buy companies at great prices.  These mismatches also may be reflected in the high dividend yields that we search for in Double Digit Dividends.

A more useful approach in evaluating P/B is therefore to combine the measures of the company’s ROE and its P/B.  To do this we use the ratio:

Returns to Price formula

The strong advantage of this ratio is if we can turn it to a meaningful number we can relate to. Specifically, if we can figure out the number of years it takes for the returns (at the price you paid for it) to pay you back twice as much by way of the company increasing its value through its annual profits (returns).

For the math aficionados, we use the following formula:

Compounding interest formula

The above formula is that of the compounding interest formula.  To determine the time it takes to double your value, set ‘P’ to $1 and ‘A’ to $2 (i.e. doubling in value) and we need to find ‘n’, the number of years it takes for the double to occur.  Finding ‘n’ requires the use of logarithms to move the n in the power and change it to a multiplier.  For those who wish to understand this more, please refer to https://math-faq.com/wp/how-do-you-solve-for-time-in-the-compound-interest-formula/

But I am no mathematics aficionado.  I like to keep it simple.  The last time I looked at calculus and logarithmic equations was at university and I am still recovering from that experience some 30 years later.  It appears that the logarithmic equation required to determine the time it takes to double your investment can be expressed in a simple rule called the “Rule of 72”.  Why take the long way if there is an expressway, right?  The formula for the rule is:

Years to Double formula

Where, “Returns to Price” is the value defined above paragraphs as the ROE divided by the Price to Book.

For more information on this formula, visit this page.

Applying the Rule of 72 to our five tobacco stocks we get the following results.  I have also included the Price/Earnings ratio for comparison purposes.

CompanyROEP /BROE / Price to BookYears to Double (Rule of 72)Price / Earnings (PE Ratio)Dividend Yield
(Net)
Philip Morris (Czech Division)43%4.010.71%6.79.39.8% for EU and EEA residents
British American Tobacco Kenya PLC40%37.01.08%66.792.68.3%
Carreras Ltd (Jamaica)271%17.615.44%4.76.56.6%
HM Sampoerna (Philip Morris Indonesia)38%4.68.31%8.712.06.8%
Eastern Company SAE32%2.413.38%5.47.510.5%

In the case of Philip Morris (Czech Division) and the Eastern Company the company’s returns are distributed to you (as a shareholder) with strong net dividend yields of 9.8% (for EU and EEA residents) and 10.5% respectively and in the form of a capital gain in its stock price that, in total, would double your investment in 6.7 and 5.4 years respectively.

HM Sampoerna also has an attractive 8.7 years to double the total return to you.  With a net dividend yield of 6.8%, most of its returns would be through an increase in its share price.  If you are a value investor, and not solely a dividend income investor, it is also a candidate for a strong buy.

British American Tobacco of Kenya does provide you with a solid annual net yield of 8.3%.  It is therefore qualifies as a BUY recommendation for Double Digit Dividends.  But with a 66-year forecast to double your invested returns, you are unlikely to see a capital appreciation in its stock price.

Again, if you are happy to collect steady dividends as an additional income and not looking for a double-bagger, British American Tobacco could still be a good investment for you. 

A strong word of caution is required when we look and use the “Number of Years” to double your investment using the Rule of 72 computation:

  1. It assumes that for each of the future years ahead the company’s ROE would be the same. Clearly, this is a big assumption.  Each years’ earnings are highly variable.  
  1. It assumes there are NO dividends paid (and therefore all of a company’s retained earnings are compounded each year). Naturally, retained earnings are reduced when a dividend payment is made.  You therefore need to make the assumption that the dividends you received are able to compound at the same, or greater, rate as the ROE interest rate.  In fact, a higher compound interest rate would be required as the dividends you received are reduced by withholding taxes.

Nevertheless, I find the Number of Years to double your investment using the Rule of 72 computation is a handy metric to use.  It gives you a “feel” as to the soundness and how “cheap” your purchase of your investment is.

I have also included the Price to Earnings (‘PE’) ratio for each company in the above table.  The ratio is commonly used by investors to gauge the multiple you are paying for each dollar of earnings of the stock. 

There is an important distinction between the PE ratio and the Years to Double calculation.  The Years to Double computation and the PE ratio, both measure how “cheaply” you are buying the company for.  But the PE ratio is a simple multiple of price paid to earnings per share.  The Years to Double your investment is a far more sophisticated measurement.  It provides the number of years it would take for you to double your investment returns taking into account the capital efficiency of the company on an annualized compounded basis. 

In Double Digit Dividends, we first and foremost look at net dividend yields as we are primarily an income fund and we like to see the returns the companies make distributed to us by way of dividends. 

We also do look at whether a company is capital efficient and whether it is trading at a good valuation, so that there is potential upside to its stock price.  We look at the Years to Double computation to help us in this analysis. 

We use it as a factor to help determine the amount of the Fund’s capital to allocate to each of our investments? For example, the Eastern Company with a 10.5% yield and 5.4 years projection to double your total investment returns would, all other factors being the same, receive a higher capital allocation in the Double Digit Dividends Fund than Philip Morris(Czech Division) and British American Tobacco (Kenya).

In conclusion, our investment recommendations are:

CompanyDividend Yield
(Net)
Years to Double (Rule of 72)Potential Recommendation
(Subject To Further Analysis)
Philip Morris (Czech Division)9.8% for EU and EEA residents6.7Potential BUY recommendation for EU and EEA residents.
Potential "Fill-In" recommendation for the Fund - a WHT of 35% and a net yield of 7.5%. Short 6.7 years to potentially double your investment.
British American Tobacco Kenya PLC8.33%66.7Potential "Fill-In" Recommendation for the Fund. Long, over 66 years, to double your investment. A smaller capital allocation to the investment is therefore warranted.
Carreras Ltd (Jamaica)6.58%4.7NOT a BUY Recommendation.
Currency Risk (see J#25) and too low a net dividend.
HM Sampoerna (Philip Morris Indonesia)6.77%8.7NOT a BUY Recommendation for Double Digit Dividends with a 6.8% dividend yield. If, however, your mandate is to seek returns via share price appreciation, it is a value stock with a 8.7 years to double your investment.
Eastern Company SAE10.53%5.4Strong candidate as a BUY recommendation for the Double Digit Dividends Fund. Has both a double digit net dividend yield and the potential to double your total investment in 5.4 years.

This concludes our fourth and final journal on analyzing our five selected tobacco stocks.  My next journal will address the subject of Socially Responsible Investing and the importance of having a clear conscience.

Socially Responsible Investing (‘SRI’) has seen global and large asset managers reduce their exposure to investing in tobacco companies.  We can see the effect of SRI in articles such as here and here.  What is that saying by Sir John Templeton?  “To buy when others are despondently selling and to sell when others are avidly buying requires the greatest fortitude.”

There is also a general perception that government health programs and the introduction of e-cigarettes are taking a toll on tobacco companies’ earnings. As you have seen in our 4-part analysis, this simplistic conclusion is questionable. There is simply no diminution in earnings of the 5 tobacco stocks we looked at (refer to Journal #24).  Tobacco stocks continue to remain a highly capital efficient business with a highly addictive product.

There are several other tobacco names worth exploring.  Double Digit Dividends shall be analyzing tobacco stocks further.  I like to buy stocks when others are selling, especially when they give you a healthy and lucrative return in terms of dividends and potential capital appreciation.

Until then, good investing.

Peter