Wednesday, February 15, 2017

Are you ignoring investment risks you know about?

I have always had a deep fascination with investing. I like learning about different ways to make money, strategies, and investments. It is always fascinating to watch how others make money in the markets, as you can always learn something from it.

Several months ago I watched a Netflix documentary called “ The Pit”.  It is a documentary about open outcry trading, where people buy and sell futures on an exchange floor. A long time ago, stocks, bonds and commodity futures were traded by actual humans on a trading floor ( think NYSE for stocks or the movie " Trading Places") For 20 years, one trader said, they were told that the exchange will become electronic. Yet, it never became electronic. As a result, it was a running joke that it would become an electronic exchange one day. When it did, many of these people were out of a way to earn a livelihood.

So how does it relate to me as a dividend investor? Long term readers know that my biggest investments are in the likes of Altria (MO) and Philip Morris International (PM). Combining Philip Morris International and Altria, I have a decent sized allocation to tobacco.

When you know about a risk, you can purposefully choose to ignore it, because so far it is no problem. However, this could come back to bite you. Am I doing the smart thing by simply ignoring the risks behind tobacco?

We all know tobacco is harmful to humans. There is always the looming threat that governments ban tobacco products or make them unprofitable to sell. On the other hand, these products are addictive, carry fat profit margins, and fill in state tax coffers in a way that makes it unlikely that this will happen overnight. If you ban tobacco, politicians need to find another scapegoat to replenish those lost tax revenues. This would be unpopular with voters.  Even with decreasing demand, the fact that demand for those products is inelastic, we can have higher profits merely by raising prices.

Tobacco companies are cash machines, which is why they have been excellent dividend growth stocks. On the other hand, we all know that past performance is not a guarantee for future results.In support of this, the tobacco company Altria has been the best performing stock on the S&P 500 since 1957. The company tried to diversify into other venues such as food in the 1980s. It ultimately ended up spinning off Kraft in 2007, and spinning off its international operations PMI in 2008.

Altria (MO) does all of its business US, where states need revenues. The company grows through pricing increases and acquisitions. Taxing the evil tobacco industry is easy. In addition, Altria owns 10.60% of Anheuser-Busch InBev (BUD).  The company earned $1.48/share in 2008 and is expected to earn $3.30/share in 2017. Altria has raised its quarterly dividend from 29 cents/share in 2008 to 61 cents/share in 2016. Altria has managed to raise dividends for 47 years in a row. It would be attractively valued on dips below $66/share. Check my analysis of Altria for more information about the company.

Philip Morris International (PM) does business internationally, in different countries, and under different laws and regulations. Some regulations have some catching up to do with the US, while others are overly strict and prohibitive. In some jurisdictions demand is actually growing, rather than decreasing.  I foresee 20 years from now, tobacco will be still here. But I doubt it makes sense to add much more to PMI these days, due to the huge risks. The company earned $3.30/share in 2008 and is expected to earn $4.76/share in 2017. PMI has raised its quarterly dividend from 46 cents/share in 2008 to $1.04 /share in 2016. PMI has increased dividends in every single year since it was separated from Altria in 2008. It would be attractively valued on dips below $95/share. Check my analysis of Philip Morris International for more information about the company.

Given the fact that I have a well diversified portfolio consisting of roughly 100 individual securities, I think that I am protected from sector risks. In addition, since I reinvest dividends strategically, I am able to allocate those tobacco dividends into other companies and industries. All of this will pay dividends for decades to come, even if tobacco is outlawed tomorrow.

It is important to keep learning about investments every single day. This way you can be better, smarter, faster and nimbler than everyone else. The best lessons are learned from personal experience, although you can also learn a lot from others as well.

It is also important to mitigate risks, while also not avoiding them altogether. Not taking any risk can be risky by itself. The people who have subscribed to "ethical investing" and avoided sin stocks such as tobacco and alcohol, have cost themselves billions of dollars in lost opportunity costs. Taking calculated risks in tobacco companies at attractive valuations makes sense for those with diversified dividend portfolios. If I were just starting out today, I would consider investing in the likes of Altria (MO), Philip Morris International (PM) and British American Tobacco (BTI) for my diversified dividend portfolio as long as they meet my initial requirements of:

1) Growing dividends per share for at least a decade
2) Growing earnings per share over the past decade
3) Having a P/E ratio below 20

Thank you for reading!

Full Disclosure: Long PM and MO

Relevant Articles:

Altria Delivers Dependable Dividend Growth and High Total Returns
Is Ethical Dividend Growth Investing Possible?
The most important metric for dividend investing
The Perfect Dividend Portfolio

Popular Posts