Everything Not As It Seems

Every now and then, a reader will want to know what kind of formula can be easily plugged in to figure out what stocks to buy. I can think of useful approximations to get the process started. If a newbie investor only considers companies that have been raising dividends for 20+ years with earnings per share growth of at least 5% annually over the past ten and then selectively removes the financial and tech companies from the list, he will put together a pretty darn good portfolio. It’s not a perfect test—companies like Dr. Pepper and Hershey would be great lifelong holds even though they don’t have the dividend history due to buyouts and a two-year dividend freeze. And I would much rather own those companies than something like Vectren that has been raising its dividend every year for decades.

But despite those limitations, it’s still a pretty good test. The dividend mandate tells you a lot about the quality of the management and the business through the down cycles. The insistence on 5% earnings per share growth over the past decade gives you a good idea of the company’s relevance in the modern era. It’s also a long enough to give you an idea of actual business performance rather than the recency bias of short-term struggles that can be fixed. And then you manually exclude the industries that pose the greatest risk of permanent capital loss, so you don’t fall into the trap of buying something like Lehman Brothers where everything looks right on the outside with rapidly growing dividend payments only to go up in smoke later when the world learns that large, contractually due debt payments were being funded by short-term customer deposits.

Of course, those methods can give you a pretty good idea of what companies to buy, but they do not give you an idea of what the correct price to pay for the company will be. And I don’t a chart or historical P/E formulas can be the right proxies on which to make decisions either because there are so many factors that can affect what goes into the numbers to distort reality.

Take something like Philip Morris International. It is a very unique stock because it is the only large-cap company in the world that is domiciled in the United States but generates nearly 100% of its revenues outside of the United States. That was the terms of the 2008 Altria spinoff; Altria got to keep the intellectual property behind Marlboro in the United States, and Philip Morris International got Marlboro for the rest of the world. The implication of Philip Morris International’s business model is that currency fluctuations have an outsized effect on the company, as a strong dollar would paint a picture that is worse than the underlying reality and a weak dollar compared to global currencies would exaggerate the reality.

If you follow the financial media on Altria, you will likely read stories about struggling market share in Russia and declining earnings per share that criticize the company. After making $5.26 per share in profits in 2013, Philip Morris International reported profits of $4.76 in 2014 and is expected to report profits of $4.40. With the quarterly dividend at $1, it appears to the layman as if Philip Morris International is paying out 91% of its profits as dividends with only $0.40 retained for management to invest.

But if you read page 25 of the annual report, you will see that Philip Morris really earned $5.26 per share in 2014 but had the company reported that $0.80 was taken off the figure due to negative currency effects. That’s why investors saw the number turn towards $4.76 in 2014. It wasn’t the profits of tobacco products in Russia, East Asia, Africa, and Western Europe that had declined, but rather, the decline was the result of the translation from Rubles and Euros to U.S. Dollars.

On page 26 of the annual report, the company tells you in plain language that it expects to grow profits 8% to 10% this year, without factoring in the effects of currency swings that will make the actual reported profits appear worse.

It states the following under the 2015 Forecasted Results tab: “On February 5, 2015, we announced our forecast for 2015 full-year reported diluted EPS to be in a range of $4.27 to $4.37, at prevailing exchange rates at that time, versus $4.76 in 2014. Excluding an unfavorable currency impact, at then prevailing rates, of approximately $1.15 per share for the full-year 2015, the reported diluted earnings per share range represents an increase of 8% to 10% versus adjusted diluted earnings per share of $5.02 in 2014. This forecast includes incremental spending versus 2014 for our Reduced-Risk Product, iQOS. The spending, which is skewed towards the second half of the year, will support our plans for national expansion in Japan and Italy, as well as pilot or national launches in additional markets, later in 2015. This forecast does not include any share repurchases in 2015. The company will revisit the potential for repurchases as the year unfolds, depending on the currency environment.”

This is why I don’t advocate making decisions based on historical P/E ratios. It can be useful if you control the results for interest rate changes, currency changes, one-time writeoffs, and changes in expected growth from that point onward, but by the time you have done all that you’ve actually analyzed the company rather than relied on something like a Yahoo Chart to make decisions.

Philip Morris International isn’t the only company experiencing this. Coca-Cola now makes 80% of its revenues outside the United States, making the reported earnings per share figures imperfect for making decisions without recognizing the effects of negative currency on the bottom line. What usually happens is that when the dollar weakens, the results look better and the stock price advances even though the underlying business is performing substantially similar. It’s just the optics of currency swings distorting the business reality.

It’s an important thing to keep in mind because it means that some companies are cheaper than they appear. For something like Dr. Pepper, what you see is what you get. It makes all of its profits in the United States, and it hasn’t had a large writeoff in a few years since rearranging a licensing agreement with Coca-Cola (most people don’t know this, but Dr. Pepper used to manufacture nearly all of its drinks in St. Louis, and had trouble getting its product around the country on a consistent basis. So it entered a licensing agreement with Coca-Cola to distribute across the country for a small fee. So if you get miffed at Coca-Cola and drink Dr. Pepper as a boycott, you’re still sending a few cents to Coca-Cola’s headquarters in Atlanta. The net effect of all this is that Dr. Pepper has moved a lot of operations to Texas and Vermont to try and establish its own network, but actually sold most of its international and distribution rights to Coca-Cola in the process. That’s why you don’t get to drink Dr. Pepper in Ireland—Dr. Pepper is refusing expansion beyond North America because of the terms of its licensing agreements with Coca-Cola).

But especially with companies that are headquartered in the United States but make the bulk of their profits elsewhere, the reality is different from the headlines. People writing about Philip Morris International see the declining earnings per share that gets reported, and write about business troubles that manifest itself in higher payout ratios and stagnating results from Russia. The reality is that Philip Morris International yields nearly 5% and is growing profits in native currencies by 8% to 10% per year. What you see in the GAAP accounting is quite different from the economic reality of the business, and you can make a lot of money when you can figure out the understated cases ahead of time.