Making Long-Term Investments In Declining Industries

Many of you are aware that tobacco stocks have been excellent investments despite experiencing a simultaneous drop in sales growth that hampers the industry on an annual basis. If you were contemplating an investment in the old Philip Morris in 1981, and you were informed that cigarette sales would decline by 3.5% annually between 1981 and 2015, would you still be interested in making the investment? Would you have any idea that the investment would go up to deliver 20% annual returns from that point forward, giving you an ownership position in Philip Morris International, Altria, Mondelez, and Kraft-Heinz?

A similar story has played out for railroads. In 1900, the railroad industry represented 63% of the American stock market. If you were a dividend investor in 1900, it almost certainly meant that the bulk of your wealth would be coming from railroad dividends. And yet, railroads currently make up less than 1% of the American economy.

The funny part? Railroad stocks actually outperformed the overall stock market between 1900 and 2015 while the overall importance of the industry shrank from 63% to 1%. If you invested $100 into the general stock market in 1900, you would have $3,910,000 today. If you invested $100 into an index of large American railroad companies in 1900, you would have $6,270,000 today. Railroads significantly lagged the growth of the rest of America over the past 115 years, yet railroad shareholders did better than general market investors.

It is important to understand the mechanics that lead to these non-intuitive results. Much of it has to do with the combination of timeless principles we see over and over applied to the outperformance of sectors like tobacco and oil. It is the intersection of chronic undervaluation mixed with higher than usual dividend payments.

For a variety of reasons, railroad stocks were cheap for much of the past 115 years, especially during the 1950s and 1960s. People feared that cars and planes would doom rails. Railroads got placed in transportation indices alongside airline stocks that performed poorly, creating a horns bias in which rail’s association with airlines disincentivized investors from seriously considering the sector. And plus, there was the Penn Central bankruptcy of 1972, which further alienated the market for railroad stocks.

Growth investors wouldn’t want to touch railroad stocks–the per share earnings growth lagged the Dow Jones Index as a whole. And conservative investors, looking for stable dividend yields, were scared off from the sector as a whole. If the companies weren’t giving you security, and couldn’t grow as fast as the market, what was the point of owning them?

The attitude created an interesting history: Although the railroad sector became a shadow of its former sale, it still delivered earnings per share that came within two percentage points annualized of the market as a whole. At the same time, the dividend payouts were 2.2x the market as a whole. The valuation was cheap, and the businesses were still growing albeit slowly, and the reinvested dividends and low prices explain why a seemingly inferior industry turned $100 into $6.27 million instead of $3.9 million.

It’s this principle that plays out in the stock market every day. If someone asked me whether Church & Dwight or Chevron would deliver stronger earnings growth over the next twenty years, the answer would be easy. Church & Dwight. But if you measure July 2015 through July 2035, I would bet that Chevron would outperform. Why? Because Church & Dwight has no business trading at 27.5x current earnings (and really, it’s 30x earnings on a normalized basis). Chevron, meanwhile,is giving investors a very nice deal by offering a 4.5% starting yield. Those reinvested Chevron dividends will propel Chevron forward, while Church & Dwight’s valuation compression from 30x normalized earnings to 20x earnings will propel it backward. This tendency gets ignored over and over again.

In fact, it’s so strong that I would wager this: The Dow Jones with Apple will underperform the Dow Jones had it held onto AT&T over the next thirty years. Siegel’s data is overwhelming–eight times out of ten–the stock kicked out of the index goes on to outperform the new entrant by one and a half percentage points per year. AT&T was trading at $32 per share at the time it got the boot, and that was arguably one of the best valuations for the stock in the past decade with the exception of the overall economic downturn in 2008-2009. The dividend yield at AT&T was nearly 6% at the time it left the index. The undervaluation of AT&T, mixed with dividend reinvestment, provides the rationale for why it may outperform Apple between now and 2045 even though the medium-term growth prospects of Apple remain more exciting.

This nature isn’t limited into the American markets. If you look at the FTSE, or the Financial Times Stock Exchange Index, which tracks the 100 largest companies that trade on the London Stock Exchange, you will see that between 1984 and 2014, companies that got kicked out of the FTSE went on to perform 9.4% annualized while the new entrants went on to deliver 8.5% annualized. Overpaying for growth, and underpaying for slow-growing stable cash flows seems to be an inherent condition for the typical market investor.

The lesson is that you should hold on to GlaxoSmithKline. You should hold on to Royal Dutch Shell. You should hold on to AT&T. You should hold on to Philip Morris International. You should hold on to The Southern Company. You should hold on to Union Pacific. They aren’t usually glamorous holdings, and there are frequent news items explaining why future growth might be limited, but it is the same scene playing out over and over again. The valuation of these companies remains low for extended time periods, and holding onto them has a much better chance of beating the S&P 500 than you’d think. And the cash income from holding them is quite nice, too.