Wednesday, November 11, 2020

Warren Buffett and Charlie Munger on Investing in Tobacco Stocks

As a dividend growth investor, I have owned shares in major tobacco companies such as Altria (MO), Phillip Morris International (PM) and British American Tobacco (BTI). I like the nature of the product being sold, the pricing power, the inelastic demand for an addictive product and the fact that these companies have managed to defy expectations. Tobacco companies have managed to grow earnings, dividends and intrinsic values over time, showering their shareholders with torrents of cash in the process. 

In fact, Altria was the best performing stock in the S&P 500 between 1957 and 2003, compounding investor capital at 19.75%/year.



Tobacco companies are under fire today for some reason, perhaps ethical investing being a chief one. Another being increased regulation that could make tobacco illegal, or somehow infringe upon their strong brands. It is possible that legalization of cannabis or the introduction of alternative tobacco products could impair the model of tobacco companies. That may explain why Altria lit several billion on fire in late 2018 by acquiring a stake in JUUL. Either way, PMI seems to be well positioned of the three companies with its iQOS product.

Perhaps investors believe that management teams have not done a good job in enhancing shareholder value. I do not know why these companies are so cheap, despite the fact that they have done a good job growing earnings ( well, sans PMI but it still has at least maintained earnings). Either way, companies like Altria, PMI and British American Tobacco are sold at very low valuations today. Even if they never grew, if these companies can at least maintain cashflows to pay their dividends, an investor can easily recoup their investment within 12 - 15 years from dividends alone.

If valuations are so low, I ask myself the question as to why wouldn't someone from the private equity industry or another consumer staple company simply go ahead and acquire the types of Altria for example at less than 10 times earnings. They could easily offer $60/share, which is perhaps 13 - 14 times forward earnings, and finance the investment with cheap long-term debt. I believe that this is due to ethical concerns. I saw an interesting video from the 1997 Berkshire Hathaway Shareholder meeting, where Buffett and Munger discuss their attitude towards investing in tobacco companies. I believe this attitude is shared by many other investors. It is possibly the reason why tobacco offers such a good valuation today. I believe it is an opportunity, but my risk averse side warns me that a high yield in this environment is also indicative of a high risk. The risk is that I am buying a value trap, which cuts dividends along the way, impairing my projections. 

You can watch the video from the 1997 meeting here: https://www.youtube.com/watch?v=c2OR0nrIClo

I am attaching a transcript too: 

"WARREN BUFFETT: Zone 6.

AUDIENCE MEMBER: My name is Michael Hooper. I’m from Grand Island, Nebraska. I applaud Berkshire for starting the Class B shares.

My question deals with tobacco stocks, which have been beaten down lately. Does Berkshire own any tobacco stocks, and are some of these stocks attractive now that prices are down on some of them? And in particular, a company called UST. Thank you.

WARREN BUFFETT: Yeah. We have owned — we won’t comment on what we own now — but we have owned tobacco stocks in the past. We’ve never owned a lot of them, although we may have made a mistake by not owning a lot of them. But we’ve owned tobacco stocks in the past, and I’ve had people write me about whether we should do it or not.

We own a newspaper in Buffalo. It carries tobacco advertising. We don’t — well, actually, Charlie’s a director of a sensational warehouse chain called Costco, which used to be called PriceCostco. You know, they sell cigarettes.

So we are part of the distribution chain in — with a hundred percent-owned subsidiary in the Buffalo News. And so we have felt that if we felt they were attractive as an investment, we would invest in tobacco stocks.

We made a decision some years ago that we didn’t want to be in the manufacture of chewing tobacco. We were offered the chance to buy a company that has done sensationally well subsequently, and we sat in a hotel in Memphis in the lobby and talked about it, and finally decided we didn’t want to do it.

Can I give you some —?

CHARLIE MUNGER: But it wasn’t because we thought it wouldn’t do well. We knew it was going to do well.

WARREN BUFFETT: We knew it was going to do well.

But now, why would we take the ads for those companies, or why would we own a supermarket, for example, that sells them, or a 7-Eleven, you know, or a convenience store that sells them or something of the sort, and not want to manufacture them? I really can’t give you the answer to that precisely.

But I just know that one bothers me and the other doesn’t bother me. And I’m sure other people would draw the line in a different way.

So the fact that we’ve not been significant holders of tobacco stocks has not been because they’ve been on a boycotted list with us. It just means that overall we were uncomfortable enough about their prospects over time that we did not feel like making a big commitment in them.

Charlie?

CHARLIE MUNGER: Yeah. I think each company, each individual, has to draw its own ethical and moral lines, and personally, I like the messy complexity of having to do that. It makes life interesting.

WARREN BUFFETT: I hadn’t heard that before. (Laughter)

We’ll make him in charge of this decision.

CHARLIE MUNGER: Yeah, no, no. But I don’t think we can justify our call, particularly. We just — we have to draw the line somewhere between what we’re willing to do and what we’re not, and we draw it by our own lights.

WARREN BUFFETT: We owned a lot of bonds at one time of RJR Nabisco, for example, some years back. And should we own the bonds and not own the stocks?

Should we own, you know — should be willing to own the stock but not be willing to own the business? Those are tough calls.

Probably the biggest distributor of — the biggest seller — of cigarettes in the United States is probably Walmart, but — just because they’re the biggest seller of everything. They’re the biggest seller of Gillette products, and they’re huge.

And you know, do I find that morally reprehensible? I don’t. If I owned — we owned all of Walmart, we’d be selling cigarettes at Walmart. But other people might call it differently, and I wouldn’t disagree with them."

I believe it is fascinating to see Warren and Charlie's attitude towards investing in tobacco companies. This is as relevant today as it were relevant in 1997. That was around the time of the Master Settlement Agreement, which basically removed a lot of uncertainty from tobacco. That was a time when tobacco companies were a bargain, but were about to become a better bargain. But long-term patient shareholders ultimately made out like bandits.

The tobacco company they are referring to from Memphis, TN is probably "American Snuff Company". It was acquired by the Pritzker Family in 1986, and sold to Reynolds Tobacco in 2006 for $3.5 billion. The Pritzker's acquired the company for $400 million in 1986. (Source)

I have also learned another mention of tobacco companies from Buffett, from the book "Barbarians at the Gate". 

"When Buffett came on the line, Gutfreund put him on a speaker phone and laid out the situation in detail. What should they do?

Go for it, Buffett advised. Once one of RJR’s largest shareholders, he knew tobacco and liked it. “I’ll tell you why I like the cigarette business,” he said. “It costs a penny to make. Sell it for a dollar. It’s addictive. And there’s fantastic brand loyalty.”

Would Buffett himself like to join forces with Salomon? No, the investor said, not this time. Cigarettes were a fine investment, but owning a tobacco company, with its social baggage and all that Death Merchant business, wasn’t a burden Buffett felt he was ready to bear. “I’m wealthy enough where I don’t need to own a tobacco company and deal with the consequences of public ownership,” he said."

It looks like Buffett and Munger understand that tobacco companies are a great investment that could be immensely profitable. However, they are concerned about their public image at this time. Ethics are personal, and beliefs vary from individual to individual of course.

Either way, I continue seeing tobacco companies doing what has made them successful for investors.

They raise prices, cut costs, and enjoy a sort of regulatory advantage, since it is impossible to penetrate the market without advertising. While volume growth has been negative in the developed world, rising prices have more than compensated for it each year and over time.

Relevant Articles:

What if Altria went to zero?

Analysis of Altria's Recent Deal Activity

Altria (MO) - a recession proof high yield dividend stock

Philip Morris International versus Altria

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