Philip Morris International stock, which had been trading around $100 per share, fell sharply to $83 per share before closing the day at $85 per share. For long-term shareholders of this international tobacco giant, the 15-17% one-day jolt is something that hasn’t been seen since the financial crisis of almost a decade ago. It is a very real reminder that the cautionary warnings about stock market fluctuations are not merely some ancient vintage proverb from your grandmother’s generation, but an actual reality that accompanies any form of equity ownership.
I have long paid attention to the success of the tobacco sector as an investment ever since I read Jeremy Siegel’s book “Stocks for the Long Haul” in which he pointed out that an investment in the old Philip Morris was the single best investment of the latter half of the 20th century, trumping even Warren Buffett’s amazing story at Berkshire Hathaway.
But I also paid attention to why the old Philip Morris success–the specific characteristics that made it an outstanding investment. The reason why tobacco outperformed was that it benefited from low valuations, low future expectations, and high dividends. The fact that a profitable business with growing earnings per share maintained those three characteristics is why the outsized wealth got created. To the extent that those characteristics ceased to be true, long-term performance of the tobacco sector would suffer.
In one of my last articles at Seeking Alpha, I wrote “Altria’s Ever-Expanding P/E Ratio” in which I pointed out that Altria’s valuation crept up to 26.5x earnings–an unsustainable level in light of Altria’s own historical norms and the perpetual regulations facing the tobacco industry. At the time, Altria stock traded at $73 per share. Most of the comments in response to my article were mocking in nature, along the lines of “Anytime this author says Altria is overpriced, I buy more!”
Fast forward a year, and the price of Altria is down to $57 per share.
The same story has paid with Philip Morris International. Last year, the stock hit a high of $123 per share compared to $4.72 per share in earnings. That was 26x earnings for a gosh darn tobacco company. That was unjustified and unsupportable.
How did it happen? People want income, and interest rates have been low. Global gas prices have been low, facilitating heightened tobacco demand. And most importantly, the past few years have been light on meaningful, kick-down-the-door tobacco regulation. That had lulled investors into complacency, believing that the worst of the regulations were over and that a New Normal Era had arrived where taxes remain high but smoking is otherwise left undisturbed.
Now, investors are realizing that the process of moving away from tobacco is a double-edged sword, analogous to Coca-Cola trying to get its customers to drink Dasani water instead. Shifting from a billion-dollar cash cow to a series of recently created contraptions carries the enormous risk that perhaps should be spelled out–what happens if someone quits smoking and grows bored with the gadgets in due time, effectively replacing a 40% profit margin business model with the adult version of Toys ‘R Us clutter?
To really feel the effect of this risk, I often read old press releases from 1998 when everyone pondered the possibility that the cigarette makers would all go bankrupt. It is an important reflection because the countries in which Philip Morris sells cigarettes are going through the same metamorphosis. You have to withstand really awful headlines, presenting really plausible wipeout risks, on a regular basis to reap the returns of the tobacco sector.
That said, the valuation of Philip Morris has shifted considerably when you compare the price of $123 last year to the price of $85 now.
The introspective investor Donald Yacktman once made an excellent observation about investing. When the price of a stock goes down by a meaningful amount, the bar for future expectations has also been lowered, making it easier for the stock to outperform the lowered bar of expectancy. I was thinking about that quote when I saw today’s news that Philip Morris International’s efforts to replace cigarettes with various smoke-blowing e-gadgets have been moving much slower than anticipated.
Last year, at $123 per share, PM was trading at 26.5x earnings. Now, with 2018 earnings expected to be $5.30 per share, the $85 share price gives a valuation of 16x earnings and a starting dividend yield of 5%. My takeaway is that Philip Morris International is now trading at a fair price that adequately compensates investors for the taxation and regulation risks in the sector. I think peg the fair value range for the stock as $75-$85 per share, putting the current valuation towards the higher range of my fair value estimate. Buffett uses the term “zone of reasonableness” to describe the band of a stock’s fair value–I would say that Philip Morris International fell from modest overvalued to the top of the zone of reasonableness today.
The 5% yield gives investors a lot of protection (especially because profits per share are still increasing). The company buys back about 1% of its stock each year. It is possible that earnings per share growth only needs to track inflation for investors to receive nominal returns of 10% annualized.
To the extent that today’s sharp drop reminds investors of the need to extract dividends from their tobacco investments, try and keep tobacco investments to less than a tenth of one’s net worth, and the crazy headline risk that affects the sector, today’s decline is probably a good thing because it is isolated from collapses elsewhere (i.e. presuming Philip Morris International shareholders are diversified, the pain of error is particularly manageable).
Also, broadly speaking, a 15% price decline is nothing. Ask the Aflac shareholders who saw every $10,000 invested in the stock in 2007 fall to $2,300 in 2009 before recovering to $10,000 in 2011 and creating a total value of $17,500 today.
The business is solvent. The profits are there. The price may fluctuate, but the enterprise itself will be standing a decade from now and chugging out cash payouts for their investors. Tobacco stock overvaluation is historically a rare occurrence, and most of that overvaluation got corrected in one fell swoop today.