I watched through the entirety of that Warren Buffett video I posted the other day when he discussed that Procter & Gamble would be a great long term holding, but not the best long term holding, because of concerns of unit growth and pricing power in response to intense competition. Buffett made an offhand comment about how a lot of money got made in large-cap stocks during the 1990s up until that point because of the outperformance of growth rates for blue chips compared to then-existing expectations. Specifically, Buffett said, if something has a 12% coupon rate and you end up getting 20%, you’re going to going to make a lot of money.
Put another way, the upshot of investing in super large corporations during the 1990s is that you not only got the benefit of owning something with extraordinarily durable profits, but you were also getting something like 8-10% earnings per share growth when the stock was only priced for something like 6% earnings per share growth.
It was an environment that created an investing triple threat. You get the benefit of owning an extraordinary business, you ended up getting the benefit of the 8-10% earnings per share growth, and then you also got the benefit of the subsequent valuation shift that came to recognize greater earnings growth than was initially priced into the stock. Perhaps this is what Peter Lynch was alluding to when he said there’s a lot of money-making action in those stodgy blue-chips most people overlook on the grounds that they are boring.
The fun thing about buying stocks like BP at $31 is that you will eventually reach a point where you will encounter some news that pleasantly surprises you (and by “surprise” I refer to timing or sequence of a favorable business development). The price permits it.
But there are other stocks where you are no longer positioned to give you any unexpected upside. The particular stock that I have in mind is Altria. It’s now priced at $62 per share. That’s 21x earnings for a business that is currently catching every break imaginable.
There’s been a cooldown in regulations and additional taxes for the sale of tobacco. Gas prices have been low, leading to an unexpected 4.5% surge in tobacco volumes (and “surge” is the right word, as tobacco have had a 3.6% decline rate from 1982 through 2010). The SABMiller stake, of which Altria owns 27%, got revalued upward 1.5x as part of Anheuser-Busch’s merger appetite. The unemployment rate for those earning under $30,000, who comprise a bit over half of the nation’s smokers, is at its lowest since the recession. This is the best 21st century operating environment that a tobacco environment could hope for. And interest rates are low, which has also perked up the demand for stocks that have historically paid large dividends to investors.
In 2014, Altria crossed $50, and that’s when it caught my attention that the price of the stock was starting to get frothy. Then, rates stayed low, and gas prices came down, and the news of the Anheuser-Busch acquisition of SABMiller hit, and the stock has been propelled to above $60 per share.
Perhaps there’s more good news for shareholders around the corner, but I don’t see it. I would say, over the next five years, that you’re more likely to see: (1) higher interest rates; (2) higher gas prices; (3) another recession at some point; (4) and the return to fashionability of new excise taxes and bans for cigarettes. The elephant in the room is plain packaging regulation, which would absolutely shatter the brand power of cigarette brands if it ever were to pass (heck, I recently bought a ‘Great Value’ razor because the packaging looked so much like Gillette that I thought I was getting the name brand on sale until I took a closer look.)
The real game-changer is the legalization of weed. If that happens, and Altria becomes an entrant and builds brands to gain a market share, it could gain new life much like how American Express shifted from checks to credit cards or Wells Fargo shifted from operating the Pony Express to lending to rail lines and cargo operators to become the dominant lender at travel posts.
The normalization of weed is a real thing with business implications–my intuition is that a supermajority of parents would rather hear that their kids smoke weed rather than cigarettes, with the minority preferring to hear of cigarette usage due to the lower legal risk–but I’m not sure how the regulatory framework for this development will build out so I’m currently agnostic on what this might mean for Altria’s future business operations.
The moral of this story? You want to go through life collecting assets at prices that give you all these possibilities for upsides, and I don’t see that with Altria right now. When the stock traded at 14x earnings or 15x earnings, and you got to collect a 6% yield, you didn’t really need a whole lot to go right to end up making a lot of money. In the case of Altria, a lot did go right, and shareholders have made a lot of money in the meantime. But the current valuation is unprecedented for at least the past two generations, and the business conditions and interest right environment couldn’t be more favorable. If I held it, I’d hold it, but otherwise, I’d wait for it to come down to below 15x earnings. That’s where it has traded at or below for almost the entirety of the past half-century, and it’s against your self-interest to engage in bull-market thinking by extrapolating the high P/E ratio of the past three years and regarding it as something that will exist for the long haul.
Originally posted 2016-04-18 15:06:48.